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nvestment  securities 


s. 


Essential  CKaracteristics 
and  Values 

By 
JAMES  R.  BANCROFT 


President,  American  Institute  of  Finance.     Manager,  Investment 

Department,  Babson  Statistical  Organization,  1917-20.     Instructor 

in  Investments,  Babson  Institute,  1919-20.     En^a^ed  in  Banking 

and  Brokerage  Business,  1907-16 


AMERICAN  INSTITUTE  OF  FINANCE 


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r  levels  for  bonds  in  terms  of  commodities  give  the  real  measure  of  opportunities  that  have  been 


Investment  b 


nvestment  Securities 

Essential  Characteristics 
and  Values 


By 
JAMES  R.  Bi^NGROFT 


President,  American  Institute  of  Finance.     Manager,  Investment 

Department,  Babson  Statistical  Org,anization,  1917-20.     Instructor 

in  Investments,  Bahson  Institute,  1919-20.     En^a^ed  in  Banking 

and  Brokerage  Business,  1907-16 


AMERICAN  INSTITUTE  OF  FINANCE 
BOSTON 


OUR 

"COMPLETE   EDUCATIONAL   COURSE" 

IN  THE  SCIENCE  OF 

MAKING   MONEY  MAKE   MORE   MONEY 

This  list  is  arranged  in  the  order  of  proper  reading.  The 
books  are  accompanied  by  a  series  of  test  questions,  key  prob- 
lems and  analyses  outlines,  enabling  the  student  to  apply  the 
knowledge  acquired  to  immediate  stock  market  and  investment 
conditions. 


1 .  Developing  Financial  Skill 

2.  Forces  Which  Make  Prices 

3.  Alanipulation  and  Market 

Leadership 

4.  Handling  a  Brokerage  Ac- 

cotmt 

5.  Market  Information 

6.  The  Essential  Features  of 

Securities 

7.  The   Value  of  a  Railroad 

Security 

8.  Industrial  Securities 

9.  Oil  Securities 

10.  Mining  Securities 


IL  Investment  Securities 

12.  Business  Cycles 

13.  Measuring   arid   Forecasting 

General    Business    Condi- 
tions 

14.  The  Technical  Position  of  the 

Market 

15.  Money  and  Credit 

16.  Business  Profits 

17.  Launching  a  New  Enterprise 

18.  Securing  Capital  for  Estab- 

lished Enterprise 

19.  Internal  Financial    Manage- 

ment 

20.  Search  for  Bargains 


Copyright,  1922  by 
American  Institute  of  Finance 


H6- 


TABLE  OF  CONTENTS 

-k  

Pafee 

Chapter  I.     Securities  as  Investments 

Purposes  of  Investment 7 

-^                  Different  Forms  of  Investment 8 

Bonds  as  Investments 9 

■^                Preferred  Stocks  as  Investments 9 

'                 Common  Stocks  as  Investments 10 

^                 Returns  on  Investments 11 

I 

■s^       Chapter  II.     Different  Types  of  Investment  Bonds 

Classification  by  Character  of  Issuer 13 

Government  Bonds 13 

Municipal  Bonds 14 

Corporation  Bonds         15 

S^J^                Classification  by  Security 15 

Different  Types  of  Mortgage  Bonds 16 

pyO                Second  Mortgage  Bonds  Rare 17 

v\                General  Mortgage  Issues 17 

N                Refunding  Mortgages 18 

^               Consolidated    Mortgages 18 

Prior  Lien  Bonds  Merit  Study 19 

^              Closed  and  Open  Mortgages 19 

V^  Classification  According  to  Maturity .20 

S\              Long  Term  Bonds 20 

^              Short  Term  Notes 21 

Serial  and  Sinking  Fund  Bonds 21 

Convertible  Bonds 22 

Coupon  and  Registered  Bonds 23 

^     Chapter  III.     Factors  Affecting  Bond  Prices 

^c-^              The  Initial  Consideration  in  Investments 25 

^^            Two  Types  of  Influencing  Factors 26 

Permanent  Factors 26 

Commodity  Prices 27 

Spending  vs.  Saving 28 

Efficiency  in  Production 29 

>^  -^        Forecasting  Long  Term  Developments 30 

^o             Temporary  Factors  Affecting  Bond  Prices 31 

Prosperity  and  Depression 31 

Effect  of  Taxation  on  Investments     .      .      .■ 32 


447469 


4  Contents 

Chapter  IV.     The  Trend  of  Bond  Prices  Pa^e 

Temporary  and  Long-swing  Movements 35 

The  Temporary  C^^cle  Movement 35 

Bond  Prices  First  to  Decline 36 

The  Long  Cycle  Movement 36 

The  Period  of  1865-1895 37 

The  Period  of  1893-1898 38 

The  Period  of  1900-1920 38 

The  Chance  of  a  Lifetime 39 


Chapter  V.     Railroad  Bonds  as  Investments 

Marketability  a  Prime  Consideration 40 

Capitalization  of  Our  Railroads 40 

The  History  of  Railroad  Development 41 

Deterioration  of  Railroad  Credit 42 

Federal  Operation 43 

Recent  Legislation 44 

The  Question  of  Valuations 45 

What  of  the  Future? 46 

Railroad  Issues  Legal  for  Savings  Banks 46 


Chapter  VI.     PubHc  UtiHty  Bonds 

Business  Stability 48 

Regulation  by  Commission 49 

Gas  Companies 49 

Electric  Lighting  Companies 50 

Electric  Power  Properties 51 

Telephone  Companies         52 

Street  Railways 53 

Rapid  Transit  Lines 54 

Surface  Lines 54 

Interurbans 55 

The  Future 55 


Chapter  VII.     Industrial  Bonds 

History 57 

Prevailing  Types 58 

Convertible  Issues < 58 

Recent  Financing 59 

Industrial  Preferred  Stocks 60 


Co ntents  5 

Chapter  VIII.     Government  Bonds  Pa^e 

Characteristics 62 

Wealth,  Debt  and  Income 62 

Liberty  and  Victory  Loan  Issues 63 

The  Market  Action  of  Liberty  Bonds 66 

The  Future 67 

Position  of  Foreign  Governments 68 

Wealth  and  Income  —  a  Comparison 68 

Methods  of  Obtaining  Income 70 

Expansion  of  Note  Issues 70 

Domestic  Securities  Preferable 72 


Chapter  IX.     Miscellaneous  Issues 

Municipal  Bonds 73 

Methods  of  Payment 73 

Tax  Position 74 

Real  Estate  Bonds 75 

Elements  of  Risk 75 

Advantages  and  Disadvantages 76 

Federal  Farm  Loan  Bonds 76 

Repayment  of  Loans 77 

General  Liability 77 

Tax  Exemption 77 


Chapter  X.     Reading  an  Offering  Circular 

Position  of  Prospective  Investor 78 

Nature  of  the  Business 79 

Location  of  the  Enterprise 79 

Capitalization 80 

Purposes  of  the  New  Issue 80 

Amount  of  the  New  Issue 81 

Security 82 

Earnings 82 

Balance  Sheet 83 

Summary 84 


Test  Questions 

Analysis  Outline  for  Utility  Companies 


CHAPTER  I 

SECURITIES  AS    INVESTMENTS 

Purposes  of  Investment 

Investment  funds  are  accumulations  from  business  prosperity 
or  successful  speculation.  The  desire  in  investing  these  funds 
is  to  conserve  principal  and  by  putting  it  to  work  to  improve 
one's  income.  Therefore,  investments  are  made  primarily  for 
the  return  they  give  and  not  for  profits.  For  example,  if  any 
individual  who  has  accumulated,  let's  say,  considerable  money, 
decides  to  use  $10,000  in  a  conservative  fashion,  he  would  not 
think  of  allowing  it  simply  to  lie  in  a  bank  at  a  low  rate  of  interest. 
If  vigorous  and  forward-looking  he  would  desire  that  such  ac- 
cumulated funds  should  earn  a  good  return  with  safety.  During 
recent  years  his  attention  would  have  turned  to  the  low  prices 
for  long  term  investment  securities.  He  could,  for  example, 
have  purchased  $10,000  West  Shore  Railroad  First  Mortgage 
4's,  2361.  In  doing  so  he  would  have  had  an  absolute  first 
mortgage  on  a  railroad  property  that  would  give  him  an  annual 
return  on  his  money  of  5^%  or  an  annual  income  on  an  invest- 
ment of  $10,000  of  $550.  It  is  this  annual  income  that  interests 
him  primarily.  The  question  of  whether  the  market  price  of 
his  investment  purchase  is  four  or  five  points  lower  than  six 
months  previous,  or  will  be  four  or  five  points  higher  six  months 
later,  is  not  of  prime  importance. 

It  is  in  this  way  that  investment  differs  from  speculation. 
We  must  grasp  this  difference  immediately.  Speculations  are 
made  absolutely  for  profit.  Investments  are  made  primarily 
for  income.  While  the  desire  to  improve  or  at  least  maintain 
the  principal  of  an  investment  must  always  be  present  in  order 
to  have  the  investment  successful,  the  primary  purpose  is  to 
bring  in  additional  income. 


8  Investment    Securities 

Different  Forms  of  Investment 

Placing  money  in  a  savings  bank  is  an  elementary  form  of 
investment.  The  advantages  of  this  form  of  investment  are 
that,  except  in  extremely  critical  times,  the  money  can  be  with- 
drawn immediately  at  its  full  value.  The  price  paid  for  this 
privilege  is  the  relatively  low  return  or  income  received  from 
such  an  investment.  Savings  banks  are  an  excellent  form  of 
investment  for  the  uneducated  individual  and  for  the  man  who 
does  not  care  to  or  is  not  in  a  position  to  study  the  fundamentals 
underlying  investment  values. 

Insurance  may  be  called  another  form  of  investment 
although  the  primary  purpose  of  insurance  is  protection.  The 
first  thought  of  every  young  man  with  growing  responsibilities 
should  be  toward  this  form  of  investment.  A  growing  family 
needs  protection. 

Investments  that  give  good  returns,  however,  and  which 
appeal  strongly  to  the  average  business  man,  are  securities 
and  to  some  extent  real  estate.  We  will  treat  primarily  of 
securities  as  investments.  The  strongest  and  most  satisfactory 
form  of  investment  security  is  bonds.  A  bondholder  is  in  the 
same  position  as  the  lender  of  money.  He  has  a  direct  claim 
against  the  assets  of  the  borrower.  With  the  increasing  in- 
dustrial prosperity  of  the  past  ten  years,  and  perhaps  to  greater 
extent  with  the  increasing  income  taxation  of  the  past  five  years, 
preferred  stocks  have  become  a  common  form  of  investment. 
The  income  received  by  any  individual  from  bond  purchases  is 
subject  to  both  the  federal  normal  and  super-taxes.  The 
income  received  from  investments  in  preferred  stocks,  on  the 
other  hand,  is  exempt  from  the  normal  federal  income  tax. 
Under  war  and  post-war  taxation,  the  net  income  received  from 
a  preferred  stock  paying  6%,  is  quite  a  little  larger  than  the 
net  income  received  from  a  bond  paying  the  same  rate. 

Of  equal  or  greater  importance  perhaps  in  accounting  for 
the  popularity  of  preferred  stocks  as  investments  has  been  the 
tax  situation  of  the  issuing  corporation.  Corporations  have 
been   allowed   to  count  money   received   from   selling  preferred 


Securities   as    Investments  9 

stock  as  invested  capital.  They  were  allowed  a  basic  exemption 
on  invested  capital  under  the  war  excess  profits  tax  law.  Money 
obtained  by  selling  bonds  could  not  be  counted  as  invested 
capital.  It  is  simply  borrowed  and  the  company  agrees  to 
return  it  at  a  certain  fixed  date  in  the  future. 

The  common  stocks  of  certain  properties  that  have  paid 
dividends  uninterruptedly  for  a  number  of  years  are  considered 
investments  by  some  individuals.  Stocks  of  such  properties 
are  called  seasoned  common  issues. 

The  risks  in  these  various  forms  of  investment  will  be 
discussed  and  carefully  considered. 

Bonds  as  Investments 

Bonds  with  very  few  exceptions  carry  a  definite  promise  as 
regards  the  payment  of  principal  and  interest.  The  bondholder 
simply  stands  in  the  position  of  a  lender.  For  example,  the 
owner  of  $1,000  Pennsylvania  Railroad  General  Mortgage  5's, 
1968,  has,  in  effect,  loaned  the  Pennsylvania  Railroad  $1,000  on 
which  he  receives  a  stipulated  interest  payment.  The  company 
also  agrees  to  repay  the  principal,  $1,000,  in  1968.  In  the  event 
of  the  failure  of  the  Pennsylvania  Railroad  to  pay  either  the 
interest  on  this  loan  when  due  or  the  principal  when  due,  the 
owner  has  the  same  right  of  foreclosure  as  the  holder  of  a  per- 
sonal mortgage  note.  In  view  of  the  form  of  corporate  enter- 
prise bondholders  cannot  and  do  not  act  individually  in  event 
of  default  of  interest  or  principal.  A  committee  who  looks 
after  the  interests  of  the  large  number  of  scattered  bondholders 
is  formed  which  is  called  a  protective  committee.  The  princi- 
pal is  exactly  the  same,  however,  as  in  an  individual  loan. 

Preferred  Stocks  as  Investments 

A  stockholder,  on  the  other  hand,  whether  preferred  or 
common  is  not  a  creditor  of  a  corporation  but  is  a  partner  in 
the  enterprise.  As  stated  above,  a  corporation  or  company  is  a 
borrower  of  money  through  its  bonds.  The  bondholder  is  a  lender. 
Stock  certificates  are  merely  an  evidence  of  ownership.  They 
certify  a  share  in  the  fortunes  and  risks  of  business  enterprises. 


10  Investment  Securities 

Preferred  stocks,  however,  have  come  to  be  a  broad  medium 
of  financing  by  corporations  because  of  their  favorable  situa- 
tion in  regard  to  taxes,  as  pointed  out  above.  Such  financing 
has  been  made  attractive  to  investors  by  surrounding  pre- 
ferred issues  with  restrictions  intended  to  protect  the  purchaser. 
The  clearest  way  to  make  this  plain  is  by  a  specific  illustration. 

The  Goodyear  Tire  &  Rubber  Company  in  offering  its  pre- 
ferred stock,  agreed  that  the  dividends,  which  were  fixed  at  7%, 
should  be  cumulative.  That  means  that  in  return  for  the  stock- 
holder agreeing  to  accept  maximum  payment  of  7%  the  company 
agrees  that  if  the  full  7%  dividends  are  not  paid  in  any  one  year 
it,  nevertheless,  tries  to  assure  ultimate  payment  of  the  full  7% 
and  all  unpaid  back  dividends  before  any  distribution  can  be  made 
to  common  stockholders.  This  is  about  as  favorable  an  offer 
as  could  be  made  to  preferred  stockholders  as  they  could  not, 
being  partners  and  not  creditors,  have  the  right  of  foreclosure. 
The  Goodyear  Tire  &  Rubber  Company  further  agreed  to 
maintain  its  assets  at  the  equivalent  of  200%  of  the  preferred 
stock  to  be  outstanding  and  to  maintain  its  current  assets  at 
110%.  It  agreed  not  to  mortgage  its  property  without  the 
consent  of  75%  of  the  preferred  stockholders  and  it  placed  a 
sinking  fund  of  2|%  annually  on  the  preferred  stock  issued. 
In  other  words  it  tried  to  insure  the  stockholder  against  a  frit- 
tering away  of  its  assets.  It  also  protected  the  stockholder 
through  the  sinking  fund,  which  retires  2^%  of  the  stock  out- 
standing annually,  thus  apparently  constantly  increasing  the 
strength  of  the  balance  remaining.  In  spite  of  such  restrictions, 
however,  the  right  of  foreclosure  in  event  of  difficulties  was 
lacking,  and  in  the  difficulties  of  1921  these  restrictions 
amounted  to  practically  nothing.  Preferred  stockholders 
are  now  subject  to  $55,000,000  bonds  and  a  large  issue  of 
prior  preferred  stock  has  been  placed  ahead  of  them. 

Common  Stocks  as  Investments 

Bearing  in  mind  that  a  stock  is  simply  a  certificate  of  partner- 
ship in  an  enterprise,  and  that  common  stocks  cannot  be  sur- 
rounded with  restrictions  as  preferred  stocks  can,  it  is  evident 


Securities   as   Investments  11 

that  the  puixhase  of  common  issues  as  investments  is  quite 
hazardous.  Fluctuating  earnings  with  periods  of  prosperity 
and  depression  are  reflected  acutely  in  the  earnings  shown  on 
common  stocks.  Even  stability  of  earning  power  over  a  number 
of  years  is  not  sufihcient  insurance  of  continued  safety.  Note, 
American  Sugar  Common.  Other  illustrations  of  this  fact  are 
the  situations  of  the  common  stockholders  of  New  Haven,  Boston 
&  Maine,  Chicago,  Milwaukee  &  St.  Paul.  These  stocks  were 
considered  by  many  to  be  conservative  investments  a  few 
years  ago.  Yet  today  none  are  paying  dividends  and  all  are 
selling  for  less  than  50%  of  their  par  value.  Common  stocks 
furnish  attractive  mediums  for  speculation  but  rarely  for 
investment. 


Returns  on  Investments 

In  making  investments  clients  will  find  that  the  majority  of 
banking  and  brokerage  houses  give  the  return  obtained  in 
terms  of  yield.  For  example,  if  a  5%  bond,  due  in  25  years,  is 
offered  to  the  investor  at  80,  the  yield  on  the  investment  is 
6.70%;  but  let  us  consider  what  this  includes.  A  pencil  and 
paper  will  show  that  a  5%  bond,  bought  at  80,  paying  in  other 
words  $50  on  an  investment  of  $800,  gives  a  return  of  6.25%  a 
year,  not  6.70%.  The  yield  of  6.70%  takes  into  consideration 
that  25  years  hence  the  investor  who  today  buys  a  $1,000  bond 
for  $800  will  receive  repayment  of  his  principal,  $1,000. 

This  yield  of  6.70%  cannot  be  figured  easily  by  an  individual. 
It  is  apparent  that  no  portion  of  the  $200  premium  that  will 
be  received  25  years  hence  is  obtained  in  any  year  prior  to  the 
maturity  of  the  bond.  Again  in  figuring  the  yield  on  a  bond 
the  presumption  is  made  that  the  income  received  annually 
would  be  reinvested  as  received  at  the  same  average  interest 
rate  as  the  annual  return.  The  yield  on  investments,  therefore, 
can  be  figured  only  through  a  mathematical  process.  It  is  obtained 
for  every -day  use  by  referring  to  tables  of  bond  values  published 
for  the  purpose.  The  annual  return  on  an  investment,  however, 
can  be  obtained  simply,  as  shown  above,  hv  dividing  the  income 


12  Investment  Securities 

received  by  the  price.  When  only  annual  return  is  considered 
by  an  investor  in  figuring  his  income,  the  approach  of  the  bond 
to  its  par  value  as  it  nears  maturity  can  be  figured  as  apprecia- 
tion. We  feel,  therefore,  that  in  order  to  have  an  accurate 
account  of  yearly  income  clients  ought  to  give  greater  weight  to 
annual  return  in  purchasing  investments  than  to  so-called  yield. 


-i 


CHAPTER  II 
DIFFERENT   TYPES   OF   INVESTMENT  BONDS 

Classification  by  Character  of  Issuer 

Investing  is  a  science;  speculation  an  art.  Investing  must 
be  based  on  scientific  principles  and  classification. 

There  are  numerous  ways  of  classifying  investment  securi- 
ties. In  order  to  treat  the  situation  thoroughly  we  will  discuss 
their  classification  from  the  standpoint  of  the  issuer,  from  the 
standpoint  of  security,  and  from  the  standpoint  of  maturity. 
All  these  classifications  are  important.  The  first  classification 
divides  the  types  of  investment  securities  from  the  most  elemen- 
tary point  of  view.  The  second  allows  the  investor  to  study 
the  values  underlying  issues  offered.  The  third  brings  out  the 
question  of  permanence  or  extent  of  the  investment.  Under 
the  classification  by  character  of  the  issuer,  the  principal  divi- 
sions are  Government  Bonds,  Municipal  Bonds  and  Corporation 
Issues. 

Government  Bonds 

Government  bonds  have  always  been  considered  the  highest 
type  of  investment.  To  some  extent,  this  conception  has  been 
lowered  in  the  last  four  years.  It  has  been  found  that  under 
war  conditions  governments  can  put  out  bond  issues  at  such 
tremendous  rates  that  the  credit  of  the  respective  governments 
deteriorates  rapidly.  Developments  of  the  past  five  years  in 
Europe  have  shown  that  the  credit  behind  government  bonds 
depends  for  its  value  on  the  confidence  and  respect  which  that 
government  commands.  A  government  at  peace,  having  a 
small  debt,  levying  comparatively  light  taxes  on  its  people  and 
expressing  and  satisfying  the  ideals  and  aspirations  of  the  great 
mass  of  its  people,  has  a  high  credit.     Insofar,   however,   as 


14  InvestmentSecurities 

these  conditions  fail,  public  confidence  fails  and  credit  fails  also. 
In  other  words,  the  idea  that  has  been  prevalent  for  a  number  of 
years,  that  behind  the  bonds  of  any  nation  are  all  the  physical 
or  material  assets  of  that  nation,  is  an  illusion.  Furthermore, 
it  is  not  correct  that  the  power  to  \exy  taxes  against  such  physi- 
cal wealth  is  behind  such  bonds.  While  the  government  has 
the  legal  right  to  levy  taxes  without  limit,  there  is  a  limit  to 
its  power,  which  limit  depends  on  the  confidence  and  respect 
of  its  people.  The  real  assets  behind  government  bonds  are 
the  good  will  of  the  people  and  the  values  behind  government 
bonds  must  rise  and  fall  with  the  development  of  conditions 
that  improve  or  destroy  such  good  will. 

Municipal  Bonds 

Municipal  bonds,  so-called,  are  bonds  issued  by  our  states, 
cities,  counties  or  townships.  The  payment  of  principal  and 
interest  on  municipal  bonds  rests  on  the  taxing  power  of  the 
issuing  community.  The  taxes  are  collected  in  the  majority 
of  cases,  by  a  levy  against  the  property  of  the  issuing  munici- 
pality. This  tax  is  levied  in  direct  ratio  to  the  assessed  value 
of  taxable  property.  Such  taxable  property  includes  all  land, 
real  and  personal  estates. 

When  municipalities  issue  bonds  to  obtain  funds  f^r  proper- 
ties that  are  self-supporting  —  waterworks,  lighting  plants  or 
street  railways,  for  example  —  the  bonds  are  nevertheless 
supported  by  the  taxing  power  against  all  property.  An  ex- 
ample is  the  money  issued  by  the  City  of  New  York  to  assist 
in  the  construction  of  the  enlarged  subways,  which  has  taken 
place  in  the  last  five  years.  Increased  rapid  transit  facilities 
in  any  city  or  locality  mean  increased  property  values,  and 
thus  an  increased  assessment  value.  Hence,  all  property 
owners  are  taxed  to  provide  finances. 

Another  form  of  municipal  financing  wliich  is  not  as  promi- 
nent is  the  issue  of  bonds  the  principal  and  interest  of  which 
are  payable  from  a  special  tax  levied  only  upon  the  property 
benefited.     These  bonds  are  called  "special  assessment  issues." 


D  iff  event    Types    of  Investment  Bonds         15 

Usually  they  cover  such  operations  as  school,  highway,  or  drainage 
improvements.  The  credit  rating  of  this  class  of  bonds  is  not 
as  high  as  municipal  issues  protected  by  taxes  levied  against 
the  entire  taxable  property. 

Corporation  Bonds 

Corporation  bonds  are  our  most  common  form  of  investment 
security.  Neither  government  nor  municipal  issues  carry  a 
mortgage  claim  against  specific  property  value.  Corporation 
bonds  are  clearly  a  claim  on  the  assets  of  the  issuing  corporation 
according  to  priority  of  issue.  For  example,  a  mortgage  bond 
has  the  actual  right  of  foreclosure  against  the  particular  property 
on  which  it  is  a  mortgage.  A  debenture  bond,  so-called,  while 
not  a  mortgage,  still  possesses,  in  event  of  difficulties,  the  right 
of  foreclosure  against  the  assets,  tangible  and  intangible,  of  the 
issuing  corporation.  The  tremendous  commercial  expansion 
of  our  country  in  the  last  twenty  years  has  given  rise  to  great 
diversification  in  corporation  issues.  Whereas,  twenty  years 
ago,  the  position  of  a  corporation  bond  could  be  readily  as- 
certained from  its  description,  the  interweaving  of  securities 
has  become  so  marked  that  we  feel  it  necessary  to  point  out 
here  some  of  the  more  important  characteristics  of  the  different 
mortgage,  debenture  and  collateral  trust  bonds  that  are  put 
out  by  our  various  corporations. 

Classification  by  Security 

The  three  most  common  forms  of  corporate  bond  issues 
available  to  investors  are  mortgage  issues,  collateral  trust  bonds 
and  debentures.  Mortgage  bonds  are  exactly  what  the  name 
implies.  They  are  an  actual  lien  against  certain  physical 
property  which  is  enumerated  in  the  indenture  under  which 
the  bonds  are  issued.  That  is,  mortgage  issues  contain  an 
express  stipulation  in  regard  to  the  property  against  which 
they  are  a  mortgage. 

Collateral  trust  bonds  are  not  a  mortgage.  They  are  secured 
on  intangible  porperty,  that  is  on  other  stocks  or  bonds.     An 


16  InvestmentSecurities 

example  is  the  American  Telephone  Collateral  Trust  5's,  1946. 
The  American  Telephone  &  Telegraph  Company  is  a  holding 
company  owning  or  controlling  numerous  operating  subsid- 
iaries all  over  the  United  States,  the  majority  of  which  are 
corporations  having  stocks  and  bonds  of  their  own  outstanding. 
It  is  naturally  better  to  borrow  large  sums  infrequently  than  to 
be  in  the  market  constantly  for  small  amounts.  Therefore,  the 
parent  corporation  issues  its  own  securities,  putting  up  as 
collateral  various  stocks  and  bonds  of  subsidiaries.  The 
actual  security  of  the  collateral  trust  bonds,  it  will  readily  be 
seen,  depends  in  turn  on  the  ^•alue  of  the  subsidiary  collateral 
plus  the  somewhat  intangible  credit  of  the  holding  organization. 
Collateral  trust  bonds  must  be  carefully  studied  as  regards  the 
actual  security  or  collateral  deposited. 

Debenture  bonds  are  simply  promises  to  pay.  They  are 
bonds  that  have  the  same  credit  rating  as  promissory  notes. 
If  the  property  has  mortgages  outstanding,  the  debenture 
bondholders  must  await  the  satisfaction  of  mortgage  bondholders 
in  event  of  difiliculties  before  their  position  will  be  considered. 

Different  Types  of  Mortgage  Bonds 

The  clearest  type  of  mortgage  security  is,  of  course,  the 
absolute  first  mortgage.  We  are  familiar  with  this  bond  at 
the  present  time,  particularly  in  regard  to  real  estate.  There 
are  many  real  estate  first  mortgage  issues  outstanding.  With 
the  expansion  of  corporations  and  the  building  up  of  large  or- 
ganizations piece  by  piece,  the  "blanket  first  mortgage"  has 
largely  disappeared.  It  has  returned,  however,  in  some  of  our 
recent  railroad  reorganizations.  The  Western  Pacific  -First 
5's,  1946,  an  example,  are  a  first  and  only  mortgage  on 
about  1,000  miles  of  road.  The  difticulty  in  issuing  a  straight 
first  mortgage  issue  is  clearly  shown  in  considering  the  United 
States  Rubber  First  and  Refunding  5's,  1947.  There  arc  some- 
what over  $59,200,000  of  these  bonds  outstanding.  They  are 
an  absolute  first  mortgage  on  all  the  property  of  tlu'  company 
with  the  exception  of  the  Canadian  Consolidated  Rubber  Com- 
pany,   one    of    the    smaller   subsidiaries.     This    subsidiary    has 


D  iff  event    Types    of  1 71  vestment  Bonds         17 

$2,600,000  6's  outstanding  which  do  not  mature  until  1946. 
As  a  result,  the  later  issue  of  the  parent  organization,  the  United 
States  Rubber  Company,  simply  became  a  second  mortgage  on 
that  portion  of  the  property  and  the  bond,  as  a  result,  was  termed 
a  "first  and  refunding"  mortgage  issue. 

Second  Mortgage  Bonds  Rare 

Straight  second  mortgage  bonds  have  largely  disappeared 
from  existence.  Some  bonds  which  are  second  mortgages  are 
given  other  titles.  An  example  is  the  Colorado  &  Southern 
Refunding  and  Extension  4|'s,  1935.  These  bonds  are  a 
second  mortgage  on  about  1,072  miles  of  road  which  are  covered 
by  the  first  lien  of  the  Colorado  &  Southern  First  4's.  They  are, 
however,  a  first  mortgage  on  about  $32,000,000  subsidiary  bonds 
and  stock.  The  market  value  of  the  collateral  is  considerably 
less  than  its  par  value  and  the  real  security  of  the  bonds  is  their 
second  mortgage  lien.  The  issue  is  an  open  mortgage,  however, 
and  a  portion  of  the  bonds  are  reserved  for  improvements  and 
to  retire  the  first  mortgage  bonds  when  they  fall  due  in  1929. 
Hence,  it  is  possible  to  give  the  issue  the  name  of  "refunding 
and  extension"  mortgage  rather  than  second  mortgage. 

General  Mortgage  Issues 

General  mortgage  bonds  have  become  a  very  common  type 
of  investment.  This  title  has  taken  the  place  of  the  so-called 
"blanket  mortgage."  General  mortgage  bonds  are  a  direct 
lien  upon  the  property  of  a  corporation,  but  are  subject  to 
earlier  mortgages  placed  either  upon  certain  sections  or  upon 
the  entire  property.  General  mortgage  bonds  are  usually 
issued  in  amounts  sufficiently  large  to  take  care  of  the  underly- 
ing bonds  at  maturity.  It  can  be  readily  seen  that  the  asset 
value  behind  a  first  or  second  mortgage  bond  can  be  quickly 
figured  from  the  value  of  the  property.  The  investment  value 
of  a  general  mortgage  bond,  on  the  other  hand,  depends  perhaps 
to  a  larger  extent  upon  the  net  earning  power  of  the  property 
than  to  its  mortgage  position,  because,  particularly  when  the 


18  I  nv  e  s  tmejit  S  e  c  n  ritie  s 

underlying  liens  are  of  large  amount,  the  general  mortgage 
issue  may  be  quite  far  removed  from  the  property.  The  Chesa- 
peake &  Ohio  General  Mortgage  4|'s,  1992,  are  a  typical  issue. 
This  bond  is  secured  by  a  direct  mortgage  on  about  1,480  miles 
of  road.  It  is  a  first  lien,  however,  on  only  426  miles.  It  is  a 
second  mortgage  on  802  miles,  which  mileage  is  covered  by  the 
prior  lien  of  the  First  Consolidated  5's.  It  is  a  third  lien  on 
252  miles.  In  all,  it  is  subject  to  $42,560,000  prior  liens.  Earn- 
ing power  of  the  property  is  improving  constantly,  and  the 
bonds  have  a  high  rating. 

Refunding  Mortgages 

Refunding  mortgage  bonds,  in  the  strict  sense  of  the  term, 
are  bonds  which  have  been  issued  to  take  the  place  of  other 
bonds  falling  due  which  it  has  been  felt  desirable  to  extend 
rather  than  pay  off.  So  far  as  security  goes,  the  words  "refund- 
ing mortgage"  mean  little.  Such  an  issue  should  be  examined 
carefully.  For  example,  a  first  and  refunding  mortgage  bond 
may  be  a  first  mortgage  on  only  one-tenth  of  the  entire  property 
and  may  be  a  second,  third,  fourth  or  even  fifth  on  the  balance, 
or  it  may  be  a  first  mortgage  on  nearly  all  of  it,  like  the  Rubber 
bond.  One  of  the  well-known  refunding  mortgage  bonds  is  the 
Chicago,  Rock  Island  and  Pacific  Railroad  First  and  Refunding 
4's,  1934.  This  bond  is  secured  by  a  direct  or  collateral  mort- 
gage on  over  5,834  miles  of  road.  It  is,  however,  a  direct  first 
mortgage  on  only  815  miles.  It  is  a  first  collateral  lien  on  365 
miles,  through  the  deposit  of  bonds  and  stocks  of  subsidiaries. 
Its  real  security  is  a  second  lien  on  4,270  miles  covered  by  the 
first  lien  of  the  General  4's,  1998.  In  all,  this  bond  is  subject  to 
nearly  $75,000,000  prior  liens. 

Consolidated  Mortgages 

A  consolidated  mortgage  bond  is  theoretically  a  bond  secured 
by  a  mortgage  on  the  entire  property  of  a  company  which  is 
the  result  of  a  consolidation  of  numerous  smaller  properties. 
Here  again,  it  may  be  seen  that  the  words  "consolidated  mort- 
gage" of  themselves  mean  little  or  nothing,  as  regards  security. 


Different   Types   of  Investment  Bonds        19 

A  consolidated  mortgage  may  be  a  first  mortgage  bond  on  the 
consolidated  property  or  it  may  be  a  second  or  third  mortgage. 
Of  late  years,  consolidated  mortgage  bonds  have  been  created 
to  refund  or  retire  other  issues  which  are  prior  to  it,  but  which 
are  not  yet  due,  in  an  endeavor  to  consolidate  the  indebtedness 
of  the  company.  Here  again,  it  is  of  course  necessary  to  study 
into  the  actual  security  behind  the  issue. 

Prior  Lien  Bonds  Merit  Study 

Prior  lien  is  a  descriptive  title  that  is  much  misused.  If 
prior  lien  bonds  were  exactly  what  their  name  indicates,  they 
would  be  prior  in  lien,  or  ahead  of,  all  other  indebtedness  against 
the  property.  As  a  matter  of  fact,  prior  lien  bonds  are  often 
issued  in  cases  where,  while  they  become  prior  in  lien  to  certain 
issues,  they  are,  at  the  same  time,  subject  to  other  issues  out- 
standing. The  latter  remain  prior  in  lien,  or  ahead  of  actual 
prior  lien  mortgage  bonds.  A  good  illustration  of  this  is  the 
mortgage  bonds  issued  in  the  St.  Louis-San  Francisco  reorgan- 
ization. This  company  has  at  the  present  time  nearly  $120,- 
000,000  bonds  outstanding  under  its  prior  lien  mortgage.  These 
bonds  are  subject  to  approximately  $14,000,000  other  issues. 
In  turn,  they  are  actually  prior  in  lien  to  Adjustment  6's,  1955, 
and  Income  6's,  1960.  While  a  mortgage  on  about  4,000  miles 
of  road,  they  are  a  straight  first  mortgage  lien  on  only  1,530. 

Closed  and  Open  Mortgages 

We  have  spoken  in  the  above  description  of  open  and  closed 
mortgages.  Open  mortgages  are  to  be  found  to  a  large  extent 
in  general  or  secondary  mortgage  issues.  An  open  mortgage 
is  a  mortgage  under  which  more  indebtedness  can  be  incurred, 
or  in  other  words,  under  which  the  amount  of  indebtedness 
authorized  has  not  yet  been  reached.  A  closed  mortgage  is 
the  opposite.  No  further  bonds  can  be  issued  under  that  mort- 
gage. It  can  readily  be  seen  from  this  that  a  closed  first  mortgage 
forms  an  extremely  high  type  of  investment.  On  the  other 
hand,  an  open,  general  mortgage,  while  it  may  possess  a  high 


20  I  nv  e  s  tment  S  ecuriti  e  s 

degree  of  security,  has  many  drawbacks.  No  better  illustration 
of  this  can  be  given  than  recent  developments  under  the  Penn- 
sylvania General  Mortgage.  This  mortgage  is  open  for  large 
further  issues  of  securities  and  has  been  for  some  time.  In  April, 
1917,  $125,000,000  General  Mortgage  4|'s  were  sold  to  the 
public  on  a  4.70%  basis.  In  December,  1918,  $50,000,000 
General  Mortgage  5's  were  offered  on  a  5.10%  basis.  In  May, 
1920,  $50,000,000  General  Mortgage  7's  were  sold  at  par.  The 
result  of  this  continued  issuing  of  securities  under  the  same 
mortgage  and  under  difficult  conditions  has,  of  course,  reacted 
unfavorably  against  bonds  previously  outstanding  under  the 
same  mortgage. 

Classification  According  to  Maturity 

The  varying  needs  of  our  corporations  have  caused  the 
issuance  of  various  types  of  securities  according  to  their  date  of 
repayment.  For  example,  some  corporations  desire  to  borrow 
money  for  only  a  few  years  believing  that  the  growth  of  the 
business  will  allow  repayment  in  a  short  period  and  a  saving  of 
interest.  Other  corporations  financing  permanent  investments 
like  our  railroads,  desire  to  obtain  money  for  as  long  a  term  of 
years  as  possible,  when  money  can  be  obtained  under  favorable 
conditions.  Some  corporations,  believing  in  the  future  growth 
of  the  business,  but  not  willing  to  incur  the  obligation  for  re- 
payment definitely  in  the  near  future,  equip  their  bond  issues 
with  sinking  funds  which  retire  them  gradually.  Others  equip 
them  with  redemption  features  which  allow  the  repurchase  of 
the  bond  by  the  corporation  from  investors,  if  favorable  con- 
ditions make  such  repurchase  seem  advisable. 

Long  Term  Bonds 

Long  term  bonds  usually  run  from  25  to  100  years.  As 
stated  above  we  fmd  long  term  bonds  issued  by  corporations 
when  conditions  are  favorable  to  borrowing  money  at  a  low 
rate  of  interest.  For  example,  the  New  York  Central  has 
approximately  $350,000,000  3|%  and  4%  bonds    outstanding 


Different   Types   of  1 7i vestment  Bonds         21 

which  are  not  due  for  about  75  years,  on  which  it  is  paying  a 
very  low  interest  rate  and  which  were  originally  sold  to  investors 
at  about  par.  Long  term  bonds  should  only  be  purchased 
under  conditions  like  those  now  prevailing,  that  is  when  com- 
modity prices  and  interest  rates  are  high.  Under  such  condi- 
tions, few  new  long  term  bonds  come  into  the  market  and  the 
prices  of  those  outstanding  are  very  low.  This  situation  will 
be  treated  in  detail,  in  a  subsequent  chapter. 

Short  Term  Notes 

Short  term  notes  are  issued  under  directly  opposite  conditions. 
They  are  put  out  when  money  is  high  because  the  issuing  cor- 
poration does  not  care  to  pay  prevailing  rates  for  money  for 
any  longer  time  than  necessary.  Therefore,  it  endeavors  to 
make  the  maturity  of  its  short  term  note  fall  at  a  time  when 
refinancing  conditions  will  be  more  favorable.  If  this  is  the  true 
attitude  for  a  corporation,  it  is  not  to  the  interest  of  the  average 
investor  to  purchase  short  term  notes  when  commodity  prices 
or  money  rates  are  high  as  he  will  be  faced  with  the  necessity 
of  reinvesting  at  maturity  to  less  advantage.  He  should  buy 
long  term  bonds  at  low  prices  and  obtain  permanent  high  returns. 
Under  conditions  like  those  prevailing  in  post-war  periods  we 
can  see  why  large  issues  of  short  term  notes  are  put  out  by  cor- 
porations. 

Perpetual  bonds  are  few  and  far  between  in  this  country. 
British  Consuls  and  French  Rentes  are  types  of  perpetual  bonds. 
They  are  just  what  the  name  signifies — ■  certificates  of  indebted- 
ness bearing  a  fixed  interest  but  without  definite  maturity. 

Serial  and  Sinking  Fund  Bonds 

Serial  bonds  are  bonds  that  are  payable  in  installments. 
Serial  issues  are  largely  confined  to  municipal  bonds.  Serial 
bonds  may  be  issued  in  anticipation  of  conditions  in  the  future 
which  will  allow  repayment  of  a  stipulated  portion  of  the  prin- 
cipal year  after  year.  The  serial  nature  of  a  bond  takes  the 
place  of  a  sinking  fund. 


22  Investment  Securities 

Sinking  fund  bonds  are  bonds  carrying  a  stipulation  that 
the  corporation  agrees  to  set  aside  certain  sums,  at  stated  in- 
tervals, which  will  provide  for  the  gradual  repayment  of  all  or 
part  of  the  principal  of  the  indebtedness.  Sinking  funds  may 
be  used  in  various  ways.  The  corporation  may  be  empowered 
to  purchase  bonds  in  the  open  market  up  to  a  certain  amount 
and  at  a  price  not  exceeding  a  certain  figure.  On  the  other 
hand,  a  stipulated  price  may  be  mentioned  at  which  the  bonds 
will  be  called  in  certain  amounts  annually.  For  exam.ple,  the 
United  States  Steel  Sinking  Fund  5's,  1963,  contain  a  provision  for 
the  calling  in  of  a  stipulated  amount  of  the  bonds  yearly  at  110. 
Bonds  so  retired  are  kept  alive,  that  is  the  company  continues 
to  pay  interest  on  them  into  its  own  sinking  fund.  As  a  result, 
it  may  be  figured  out  that,  before  maturity  of  the  bonds,  the 
entire  issue  will  be  called  in  at  110.  This  forms  a  situation 
very  favorable  to  bondholders. 

Redeemable  bonds  are  sometimes  known  as  callable  bonds. 
They  are  distinguished  from  bonds  having  a  sinking  fund  in 
that  no  particular  annual  sum  is  set  aside  in  preparation  for  re- 
demption. Many  times  certain  conditions  are  stipulated  under 
which  bonds  may  be  redeemed,  but,  broadly  speaking,  redeem- 
able bonds  may  be  said  to  be  issues  on  which  the  issuer  has  in- 
dicated the  right  to  pay  his  security  off  previous  to  its  actual 
date  of  maturity.  Redemption  figures  in  the  majority  of  in- 
stances range  above  the  face  value  of  the  bond. 

Convertible  Bonds 

Convertible  bonds  have  become  a  widely  used  method  of 
financing.  They  are  bonds  which,  at  the  option  of  the  holder, 
under  certain  conditions,  are  convertible  into  other  securities, 
either  bonds  or  stocks,  issued  usually  by  the  same  corporation. 
Convertible  bonds  may  be  put  out  by  a  corporation  for  numer- 
ous reasons.  When  bonds  are  issued  that  are  convertible  into 
stock,  it  is  usually  with  the  idea  that  the  development  of  the 
company  in  years  to  come  will  bring  an  earning  power  that  will 
make  the  stock  so  attractive  that  the  conversion  privilege  will 


Different   Types   of  Investment  Bonds        23 

be  taken  advantage  of  by  investors.  The  gain  to  the  company 
is  in  eliminating  a  fixed  interest  charge.  An  interesting  illus- 
tration is  the  Chesapeake  &  Ohio  Convertible  5's,  1946.  These 
bonds  were  convertible  into  the  stock  up  to  April,  1920,  at 
$75  a  share.  From  April,  1920,  to  April,  1923,  they  are  con- 
vertible at  $80  a  share.  Chesapeake  &  Ohio  stock  in  early  1922, 
was  paying  $4  a  share  and  selling  between  50  and  60.  The  road 
was  making  progress,  and  it  was  entirely  possible  that  the  divi- 
dend in  years  to  come  might  be  increased.  If  this  was  done,  it 
will  readily  be  seen  that  the  stock  would  become  an  attractive 
exchange  for  the  bonds. 

Convertible  notes  as  well  as  bonds  are  sometimes  issued. 
The  idea,  often,  is  that  it  would  be  well  for  the  corporation  to 
have  holders  of  its  short  term  obligations  change  into  long 
term  bonds,  when  conditions  for  the  holding  of  long  term  bonds 
from  the  corporation's  standpoint  are  more  attractive  than 
those  prevailing  at  the  time  of  sale  of  short  term  notes.  Under 
such  conditions,  of  course,  the  price  at  which  the  notes  are  con- 
vertible into  long  term  bonds  is  a  figure  considerably  above  the 
selling  levels  for  the  long  term  securities  at  the  time  the  short 
term  notes  were  offered.  The  attractive  feature  of  convertible 
bonds  from  the  investment  standpoint  is  that  during  periods  of 
lax  business  or  depression  the  holder  of  indebtedness  of  a 
corporation  is  in  a  much  stronger  position  than  the  stockholder. 
At  the  same  time,  the  convertible  bondholder,  thus  protected, 
is  bound  to  profit  through  the  conversion  privilege  in  any  extra- 
ordinary prosperity  that  may  accrue  to  stockholders  during  a 
boom  period. 

Coupon  and  Registered  Bonds 

We  feel  that  before  leaving  this  descriptive  chapter,  brief 
remarks  should  be  made  on  coupon  bonds  and  registered  bonds. 
Coupon  bonds  have  certificates  attached  calling  for  stipulated 
interest  payments.  These  certificates  must  be  presented  for 
payment  when  the  interest  becomes  due.  Such  certificates 
are  made  payable  to  the  bearer  as  well  as  the  principal  of  the 


24  Investment  Securities 

bond  itself.  Registered  bonds,  on  the  other  hand,  are  of  two 
forms.  They  may  be  registered  as  to  principal  and  interest,  or 
registered  as  to  principal  alone.  A  registered  bond  is  similar 
to  a  stock  certificate.  It  has  the  name  of  the  owner  filled  in  on 
the  face  and  cannot  be  transferred  from  one  person  to  another 
without  endorsement.  A  bond  registered  as  regards  principal 
and  interest  bears  no  interest  coupons.  The  interest  is  mailed 
to  the  bondholder  directly  as  it  matures,  in  the  form  of  a  check. 
The  principal  of  the  bond  is  collected  by  endorsement  on  the 
back.  If  a  bond,  however,  is  registered  as  to  principal  only,  the 
coupons  are  attached  as  in  the  coupon  bond,  but  the  ownership 
of  the  bond  cannot  be  transferred  except  by  endorsement.  The 
argument  for  registration  of  bonds  is,  of  course,  safety.  They 
are  not  negotiable  without  endorsement.  The  marketability 
of  the  registered  bond  is  not  nearly  so  good  as  that  of  coupon 
bond  as  much  inconvenience  to  holder  and  purchaser  is  caused 
by  registration. 


CHAPTER  III 
FACTORS   AFFECTING   BOND    PRICES 

The  Initial  Consideration  in  Investments 

Safety  and  return  are  the  initial  considerations  of  all  in- 
vestments. Safety  is  the  starting  point.  After  safety  is  es- 
tablished further  energies  are  expended  in  obtaining  as  high  a 
return  as  is  possible  while  maintaining  a  good  degree  of  security. 
Security  or  safety  is  not,  however,  a  fixed  item.  A  widow, 
absolutely  dependent  upon  income  received  from  her  invest- 
ments, requires  a  wide  margin  of  safety.  In  other  words  a 
degree  of  stability  must  be  assured  which  will  prevent  any 
material  change  in  underlying  conditions  over  a  series  of  years. 
Such  investors  require  absolute  first  mortgage  bonds  of  prop- 
erties, the  value  of  which  is  many  times  the  mortgage  outstanding 
against  them.  An  investment  of  that  type,  while  high  in 
safety,  is  low  in  return. 

A  business  man,  a  young  man,  looks  in  a  different  direction. 
With  him  a  study  of  safety  becomes  one  of  degree.  Too  much 
security  costs  money.  It  brings  a  material  loss  in  income.  A 
business  man's  investment  must  have  elements  that  insure 
constant  improvement  but  it  is  not  necessary  that  in  the  im- 
mediate future  it  should  have  such  a  tremendous  amount  of 
assets  behind  it  that  its  security  may  be  termed  super-excellent. 
Therefore,  in  such  investments  a  most  careful  study  of  the 
present  and  future  governing  forces  is  necessary. 

In  any  investment  we  must  first  assure  ourselves  of  a  degree 
of  safety  sufficient  to  give  continued  interest  payments.  Other- 
wise we  change  from  investment  to  speculation.  With  such 
assurance  as  a  basis  further  energies  should  be  expended  toward 
acquiring  the  investment  that  gives  us  the  highest  return  with 
the  best  outlook  for  future  improvement. 


26  Investment   Securities 

Two  Types  of  Influencing  Factors 

Given  an  assurance  of  continued  interest  payments  and 
probability  of  constant  improvement  in  conditions  within  the 
property,  what  then  are  the  factors  that  affect  the  prices  of 
such  investment  securities?  If  the  earnings  of  the  property  are 
sufficient  and  continue  sufficient  to  insure  interest  payments,  it 
is  not  the  month  to  month  or  even  year  to  year  fluctuations  in 
net  earning  power  that  concerns  us.  What  is  it?  There  are 
two  types  of  conditions  that  affect  the  price  levels  of  investment 
securities.  The  first  type  are  those  of  long  duration  or  what 
may  be  termed  PERMANENT  FACTORS.  The  second  type 
are  those  that  fluctuate  at  relatively  short  intervals,  changing 
from  year  to  year,  or  at  least  e\'ery  few  years.  These  may  be 
termed  TEMPORARY  FACTORS. 

Permanent  Factors 

In  taking  up  the  factors  that  influence  bond  prices  over  a 
long  term  of  years,  we  must  first  remember  the  primary  point 
—  investments  are  made  for  the  income  that  they  give.  In- 
vestment bonds  are  receipts  for  money  loaned  which  the  bor- 
rower agrees  to  return  at  a  certain  specified  date  in  the  future. 
As  a  result  bonds  are  to  a  large  measure  simply  money.  We 
know  well  from  a  study  of  economics  that  money  is  valuable 
only  for  what  it  will  buy.  When  we  speak  of  prices  doubling 
we  mean  that  the  amount  of  goods  that  a  dollar  will  buy  has 
been  cut  in  half.  Another  way  of  saying  the  same  thing  is 
that  the  dollar  is  only  worth  fifty  cents.  Likewise  investments, 
giving  a  stipulated  return  uninterruptedly  over  a  series  of  years, 
depend  for  their  market  value  on  what  the  income  received 
from  them  will  buy.  In  other  words  they  fluctuate  with  the 
trend  of  commodity  prices.  When  commodity  prices  rise  the 
purchasing  power  of  the  income  from  an  investment  declines. 
Commodity  prices,  therefore,  are  one  of  the  foremost  permanent 
factors  affecting  prices  of  investment  securities. 

Investors  in  this  country  are  largely  people  of  means.  We 
have  not  yet  reached  the  position  of  the  French  people  where 


Factors   Affecting  Bond   Prices  27 

the  relatively  poor  man  purchases  investment  securities  in  small 
lots.  Thrift,  as  such,  has  not  yet  become  a  national  habit 
in  the  United  States.  It  can  be  readily  seen,  therefore,  that  the 
demand  for  investment  securities  depends  to  a  considerable 
extent  upon  the  prosperity  of  the  so-called  capitalistic  element 
in  this  country,  and  the  manner  in  which  they  use  their  profits. 
Still  another  factor  that  is  permanently  affecting  the  values 
of  investment  securities  is  the  increase  or  decrease  in  our  efh- 
ciency  in  production.  Such  increase  or  decrease  either  widens 
or  narrows  the  margin  of  profits  and  also  widens  or  narrows  the 
increase  in  material  wealth  of  the  country. 

Commodity  Prices 

When  commodity  prices,  or  the  prices  of  all  goods,  are  high, 
as  at  the  present  time,  we  are  all  aware  that  the  purchasing  power 
of  the  dollar  is  low.  In  other  words,  we  can  buy  less  goods  for  the 
same  amount  of  dollars  than  we  could  ten  years  ago.  Similarly, 
a  $50  income  on  a  $1,000  investment  buys  only  about  one-half 
as  many  goods  as  it  did  in  the  pre-war  period.  It  is  not  possible 
to  get  investors  to  loan  $1,000  today  and  be  satisfied  with  an 
annual  income  of  $40.  With  the  big  increase  in  living  costs  it 
has  been  necessary  for  them  to  demand  a  considerable  increase 
in  the  annual  return  on  their  money.  As  a  result,  it  follows 
that  a  constant  increase  in  commodity  prices  means  a  constant 
decline  in  the  prices  of  investment  securities  or  conversely  a 
constant  increase  in  the  return  received  from  them. 

No  better  illustration  of  this  situation  need  be  given  than 
that  of  the  West  Shore  First  4's,  2361.  In  1902  these  bonds 
sold  at  116,  at  which  level  the  yield  was  only  3%.  Commodity 
prices  were  then  very  low.  The  dollar  would  buy  a  great  deal 
and  a  $30  a  year  return  on  a  $1,000  investment  allowed  a  com- 
fortable existence.  The  West  Shore  First  4's  in  1920  sold  around 
65  to  give  an  annual  return  of  6%.  The  return  had  doubled. 
Similarly  the  prices  of  goods  that  we  purchase  had  doubled,  or 
perhaps  trebled  in  some  instances.  It  is  clear,  therefore,  that 
a  primary  factor  in  the  price  trend  of  investment  securities  is 
the  fluctuations  in  the  prices  of  goods. 


28  Investment  Securities 

What  of  the  future?  Study  shows  that  after  post-war  in- 
flationary periods  Hke  the  one  just  passed,  we  enter  a  period 
of  prolonged  decline  for  goods  prices.  We  know  that  we  can 
look  forward  at  the  present  time  to  the  future  with  the  confidence 
that  prices  of  goods  will  tend  lower.  As  a  result  the  prices  of 
investment  securities  will  constantly  tend  higher.  As  goods 
prices  decline  and  the  purchasing  power  of  the  dollar  increases 
the  return  offered  to  new  investors  will  also  decline.  Hence, 
an  unfortunate  situation,  from  the  standpoint  of  living  costs, 
has  meant  in  reality  an  opportunity  of  a  lifetime  for  investors. 

Spending  vs.  Saving 

A  factor  that  is  bound  to  have  a  profound  influence  on  the 
price  level  of  investment  securities  is  the  situation  in  a  nation 
in  regard  to  spending  or  sa^'ing.  We  have  had  a  most  apt  illus- 
tration of  this  situation  right  here  in  the  post-war  period.  We 
have  been  through  a  period  of  extravagant  expenditure.  Such 
periods  usually  follow  upheavals  like  wars.  Nevertheless, 
such  spending  naturally  reduces  saving  ability  to  the  minimum. 

There  are  only  two  ways  in  which  we  may  use  money.  We 
can  put  it  into  immediate  consumption  or  we  can  invest  it. 
For  this  reason,  there  is  bound  to  be  constant  competition  be- 
tvveen  objects  for  consumption  and  objects  for  investment. 
The  former  usually  win  out  during  periods  of  prolonged  pros- 
perity. Business  has  been  good;  failures  few  and  far  between, 
and  profits  have  been  expanding.  As  a  result,  individuals  have 
become  care-free  and  look  toward  the  future  in  a  desire  for 
personal  self-satisfaction.  Coincident  with  this  development 
comes  a  natural  increase  in  the  prices  for  goods  as  the  demand 
converges  on  goods  rather  than  investments.  Therefore, 
towards  the  end  of  a  period  of  j^rosperity  we  see  prices  advancing 
rapidly  and  spending  increasing,  both  of  which  have  a  very  un- 
favorable effect  on  the  prices  of  investment  securities,  the  first 
through  a  decreased  purchasing  power  of  the  dollar  and  the 
second  through  a  diversion  of  demand. 

On  the  other  hand,  let  us  see  what  happens  in  a  period  of 
depression.     A  depression  is  usually   preceded    by   a   panic   or 


Factors   Affecting  Bond    Prices  29 

crisis.  Many  firms  and  individuals  fail.  The  world  has  ceased 
to  look  rosy  and  as  a  result  the  minds  of  individuals  turn  toward 
safety  and  serious  thoughts  in  regard  to  what  the  future  holds 
forth.  Under  such  conditions,  the  abnormal  demand  for  goods 
for  current  consumption  declines  abruptly.  Prices  follow. 
Gradually,  as  competition  for  business  increases,  and  profits 
narrow  as  a  result  of  that  factor  and  lower  prices,  minds  turn 
to  security  first  of  all.  The  result  is  a  concerted  saving  and 
resulting  demand  for  investment  securities.  For  this  reason  we 
find  the  prices  of  high-grade  investment  issues  advancing  when 
general  business  is  depressed  and  speculative  securities  lifeless 
or  declining. 

Efficiency  in  Production 

Still  another  development  that  exerts  a  considerable  in- 
fluence on  the  long  time  price  level  of  investment  securities  is 
"efficiency  in  production."  The  reason  for  this  is  that  an  in- 
creavse  or  decrease  in  the  efficiency  of  production  raises  or  lowers 
the  excess  of  production  of  new  wealth.  This  naturally  widens 
or  narrows  investment  purchasing  power.  Industrial  develop- 
ment of  the  past  thirty  years  and  the  increased  productivity  of 
labor  has  certainly  resulted  in  increasing  the  surplus  wealth 
which  remains  in  the  hands  of  business  enterprisers.  This  has 
been  done  largely  through  the  development  of  labor-saving 
machinery  and  through  the  formation  of  efficient  industrial 
establishments  as  the  Ford  Motor  Company.  Here  raw  labor 
has  evolved  into  a  sort  of  semi-skilled  technique. 

Some  may  say  —  if  this  condition  has  developed  under  the 
tremendous  improved  technique  of  American  industry  in  the  last 
fifteen  years,  why  has  there  not  developed  a  very  broad  demand 
for  investments  from  business  enterprisers  that  would  have 
offset  the  declining  tendency  that  has  prevailed  in  investments? 
The  answer  is  that  this  factor  is  not  as  powerful  as  the  factor 
of  commodity  prices.  Furthermore,  at  least  for  the  time  being, 
the  increase  in  surplus  wealth  has  been  used  in  spending  for 
current   needs   rather    than    for   investing.     It   can   be    readily 


30  Investment  Securities 

appreciated,  for  example,  that  if  many  of  our  successful  business 
men  had  devoted  their  surplus  earnings  of  the  past  five  years  to 
purchasing  bonds  rather  than  automobiles  or  jewelry,  the 
depression  of  1920-21  would  have  been  less  drastic. 

Forecasting  Long  Term  Developments 

The  question  then  before  the  prospective  investor  is  two- 
fold. Under  what  conditions  are  we  standing  and  how  is  it 
possible  to  forecast  the  future  ebb  and  flow  of  developments 
underlying  bond  prices?  We  have  recently  experienced  one  of 
the  most  favorable  investment  opportunities  that  has  ever  been 
seen.  The  combination  of  tremendously  high  commodity  prices, 
coupled  with  an  era  of  extravagant  spending,  made  it  necessary 
for  everyone  to  obtain  an  abnormally  high  income,  and  invest- 
ment securities  were  on  a  very  low  level. 

What  of  the  future?  Fortunately  the  ebb  and  flow,  so-called, 
of  the  permanent  factors  above  mentioned,  does  not  come 
and  go  with  rapidity.  The  broad  fluctuations  in  commodity 
prices  in  this  country  over  the  last  hundred  years  have  occurred 
in  periods  of  from  20  to  25  years  duration.  For  example,  from 
the  beginning  of  the  Spanish  War  and  the  birth  of  business 
combinations  to  1920,  commodity  prices  have  tended  upward. 
Prior  to  1906  the  advance  was  very  slow.  In  the  next  six  years 
it  was  very  rapid.  The  rapidity  of  the  advance  denoted  its 
culmination.  A  study  of  previous  post-war  conditions  and 
the  extent  of  the  recent  period  of  rising  prices  denotes  that 
the  turn  of  the  post-war  period  of  inflation  is  permanent. 
Over  a  period  of  years  wc  should  see  a  period  of  gradual  but 
persistent  readjustment  in  whicli  commodity  prices  will  slowly 
but  steadily  decline. 

Similarly,  past  history  shows  tiiat  periods  of  reckless  spend- 
ing are  in  turn  followed  by  periods  of  what  may  be  termed  ex- 
treme conservatism.  The  average  man  spends  freely  only 
as  long  as  the  future  looks  bright.  Having  entered  a  drastic 
readjustment  period  we  can  rest  assurcfl  tliat  after  the  first 
ill  effects  are  passed  over  and  we  are  well  in  an  era  of  depression 


Factors   Affecting  Bond   Prices  31 

the  desire  for  spending  will  be  replaced  quickly  by  a  desire  for 
conservation  and  a  steady  return  on  the  principal  owned. 

The  third  factor  is  that  of  increased  efficiency  and  produc- 
tion. We  can  look  forward  to  a  constant  increase  in  this  factor 
in  this  country  with  more  than  expectation.  Post-war  eras  in 
this  nation  have  always  brought  out  new  inventions.  In  the 
years  to  come  developments  should  be  along  the  lines  of  a  more 
thorough  knowledge  and  utilization  of  the  human  being.  It 
has  been  found  that  by  better  thought-out  and  scientifically 
planned  treatment  the  average  individual  production  can  be 
increased  tremendously.  The  last  twenty  years  has  witnessed  a 
large  increase  in  productive  facilities  through  improved  machin- 
ery. The  next  twenty  years  should  see  it  through  improved 
human  beings. 

Temporary  Factors  Affecting  Bond  Prices 

Changes  in  the  temporary  factors  affecting  bond  prices 
naturally  occur  more  frequently  and  at  shorter  intervals  than 
do  the  permanent  factors  mentioned  above.  The  factor  of 
most  immediate  influence  in  bond  values  is  the  current  interest 
rate.  Under  normal  conditions  interest  rates  have  a  seasonal 
fluctuation.  Money  is  usually  easy  during  February  and  again 
in  the  summer  months.  Naturally  at  such  periods  one  would 
expect  to  find  the  bond  market  improving  somewhat.  As  a 
matter  of  fact  the  bond  market  usually  does  improve  during 
the  months  of  May,  June,  and  July.  The  February  improve- 
ment is  not  so  marked  because  in  spite  of  high  interest  rates  in 
January  there  is  a  demand  for  investment  securities  on  account 
of  the  reinvestment  of  January  funds  which  tends  to  sustain 
prices.  Such  movements,  however,  concern  the  average  in- 
vestor only  slightly  and  there  are  often  times  when  an  extreme 
movement  in  interest  rates  either  one  way  or  the  other,  which 
is  known  to  be  temporary,  has  little  or  no  effect  on  the  prices  of 
investment  securities. 

Prosperity  and  Depression 

The  broad  trend  of  the  prices  of  investment  securities  is  not 


32  I  nv  e  stm  ent  S  ecurities 

interrupted  by  minor  periods  of  prosperity  or   depression  be- 
cause,    as    explained    before,     investment    securities    properly 
chosen   give   an   uninterrupted    income   and    are    therefore   not 
particularly  affected  by  either  an  advance  or  decline  in  earnings. 
On  the  other  hand,  periods  of  prosperity  and  depression  do  have 
a  temporary  effect  on  the  prices  of  investment  securities  because 
of  their  relation  to  the  entire  security  holdings  of  an  individual. 
During  a  panic,  for  example,  bonds  sometimes  decline  because, 
in  an  endeavor  to  protect  the  equity  in  speculative  securities, 
an  individual  may  be  forced  to  sacrifice  his  investment  holdings. 
As  a  result,  temporarily,  the  excess  of  offerings  over  bids  causes  a 
drop.     Shortly,  however,  lower  commodity  prices  and  a  change 
from  an  orgy  of  spending  to  careful  saving  right  the  situation. 
On  this  account,  bonds  always  recover  quickly  from  any  so- 
called   panic   or  crisis.      During  a  period   of  prosperity,   bonds 
are  the  first  security  to  weaken  and  give  signs  of  the  approach 
of   the   end.     This   is   readily   explained   when    the   relation   of 
bonds  to  interest  rates  is  considered.     The  end  of  any  period 
of  prosperity  comes  because  the  persistent  expansion  in  business 
gradually   uses   up   the   supply   of   available   capital.     As    this 
condition  develops  interest  rates  advance  rapidly.     Bond  prices 
react  because  they  feel  acutely  any  change  in  interest  rates  and 
commodity  prices,  which  in  turn  lower  the  purchasing  power  of 
the  income  received. 

Effect  of  Taxation  on  Investments 

We  have  given  taxation  an  individual  position.  Up  to  a 
comparatively  few  years  ago  it  was  a  factor  having  little  efifect 
on  bond  prices.  With  the  developments  of  the  war  period, 
however,  it  has  become  a  permanent  factor  affecting  bond 
values.  The  result  of  direct  or  indirect  taxation  is  to  increase 
the  average  return  on  investments  or  in  other  words  to  lower 
the  price  of  old  issues.  The  reason  for  this,  of  course,  is  that  a 
certain  portion  of  the  income,  either  directly  or  indirectly  has 
to  be  forfeited.  The  natural  action  of  any  investor  is  to  en- 
large his  income  so  that  the  portion  remaining  will  give  him  the 


Factors  Affecting  Bond    Prices 


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34  Investment  Securities 

same  purchasing  power  as  before  taxation.  Another  develop- 
ment is  that,  as  taxes  increase  by  leaps  and  bounds,  there  is  a 
tendency  for  an  investor  to  switch  from  taxable  securities  into 
tax  exempt  issues.  This  in  turn,  of  course,  assists  in  bringing 
about  a  gradual  decline  in  the  level  of  taxable  investments. 
This  attempt  to  escape  taxation  has  been  the  source  of  con- 
siderable loss.  Securities  of  inferior  character  which  have  some 
tax  exempt  features  are  often  purchased  with  unfortunate 
results. 

Another  factor  adverse  to  taxable  bonds  under  prevailing 
conditions  has  been  the  federal  laws  w^hich  allow  an  investor 
to  deduct,  from  his  income,  losses  that  he  may  have  on  securi- 
ties. This  has  resulted  in  heavy  sales  of  investment  securities 
near  the  turn  of  the  year  to  establish  such  losses  and  the  pur- 
chase of  non-taxable  issues  in  their  place.  As  is  usual,  however, 
much  of  this  is  ill  advised.  The  position  of  non-taxable  and 
taxable  investments  under  recent,  tax  laws  is  shown  clearly  in  the 
table  preceding.  It  is  questionable  today  if,  in  view  of  the 
probability  of  lower  commodity  prices  and  other  improving  per- 
manent conditions  under  bond  values,  it  would  not  be  better 
for  the  investor  with  an  income  of  $50,000  a  year  or  less  to  shun 
non-taxable  securities  after  having  purchased  his  quota  Liberty 
4|'s  that  can  be  held  non-taxable  and  purchase  taxable  corpora- 
tion bonds.  This  deduction  is  not  given  because  any  material 
reduction  in  taxation  is  expected  over  the  next  few  years,  but 
because  the  fundamentals  underlying  bond  prices  should 
improve  materially  in  the  future  and  because  such  an  improve- 
ment will  find  greatest  reflection  in  the  securities  that  have 
suffered  the  greatest  depressing  influences. 


CHAPTER  IV 
THE  TREND   OF   BOND   PRICES 

Temporary  and  Long-swing  Movements 

Just  as  the  factors  that  affect  bond  prices  must  be  divided 
into  two  classes,  temporary  and  permanent,  the  trend  of  bond 
prices  must  be  divided  into  two  phases,  the  temporary  and  the 
long  swing.  Temporary  movements  of  prices  are  naturally 
influenced  by  the  changes  in  such  factors  enumerated  in  the 
previous  chapter,  long-swing  movements  by  the  permanent 
factors. 

The  Temporary  Cycle  Movement 

We  will  start,  for  example,  early  in  a  period  of  depression: 
let  us  say  the  short  depression  immediately  following  the  panic 
of  1903.  At  that  time,  bond  prices  were  on  a  low  level,  brought 
there  through  the  extreme  liquidation  of  the  panic  of  1903.  This 
was  called  the  panic  of  undigested  securities.  Immediately 
after  the  liquidating  movement  had  dried  up,  business  declined 
perceptibly  while  banking  reserves  and  deposits  increased 
rapidly,  due  to  small  demand  for  money  and  goods.  As  a 
result  of  these  conditions  money  accumulated  and  interest  rates 
declined.  Commodity  prices  fell  because  slack  business  brought 
increased  competition  and  price  cutting.  Let  us  now  remember 
that  the  big  factor  always  underlying  the  movement  of  bond 
prices  is  the  purchasing  power  of  the  income  received  from  them. 
The  above  developments  bring  an  increase  in  the  purchasing 
power  of  the  dollar.  Therefore  sound  bonds,  the  interest  re- 
quirements of  which  are  covered  by  a  good  margin  in  depression 
periods  as  well  as  prosperity,  began  to  advance  soon  after  the 
brief  depression  of  1903-1904  set  in. 

In  the  course  of  a  few  months  business  liquidation  was  com- 


36  I  nv  e  s  tm  en  t   S  e  ciiri  tie  s 

pleted.  We  then  again  started  on  the  upward  leg  of  the  busi- 
ness cycle  which  has  been  described  by  Dr.  Hickernell  in  his 
text,  "Business  Cycles."  During  this  improving  business 
movement,  bond  prices  were  showing  a  continuation  of  the 
advance  begun.  The  purchasing  power  of  the  average  individ- 
ual was  enlarged  in  the  depression  period,  and  as  a  result,  the 
demand  for  bonds  broadened. 

Bond  Prices  First  to  Decline 

This  improvement  for  a  time  was  coincident  with  the  natural 
advance  in  the  stock  market  that  goes  on  in  such  a  period.  In 
the  intermediary  or  early  stages  of  the  period  of  prosperity 
bond  prices  are  much  higher  than  in  any  other  period.  As  the 
\olume  of  business  expands  rapidly  and  prosperity  abounds, 
the  demand  for  both  goods  and  money  naturally  enlarges.  As 
a  result,  interest  rates  advance  sharply  and  commodities,  to 
some  extent,  as  demand  exceeds  supply.  In  other  words,  the 
purchasing  power  of  the  dollar  diminishes  perceptibly.  This 
was  the  condition  that  prevailed  in  1906.  This  cutting  down 
of  the  purchasing  power  of  the  dollar  diverts  investment  de- 
mand from  bonds  to  securities  having  speculative  possibilities. 
As  a  result,  a  wave  of  speculative  enthusiasm  ensues,  as  in  the 
last  months  of  1906,  and  bond  prices  decline.  We  have,  there- 
fore, the  barometer  of  declining  bond  prices  as  one  of  the  first 
indications  of  the  approaching  end  of  a  period  of  prosperity. 
The  stock  market  w^as  very  strong  late  in  1906,  but  the  bond 
market  showed  a  distinct  weakness.  The  movement  of  bond 
prices  dealt. w'ith  above,  such  as  1903-1906,  are  really  inconse- 
quential as  far  as  the  long  swing  movement  of  prices  go,  and  do 
not  concern  investors  as  vitally  as  the  latter. 

The  Long  Cycle  Movement 

The  rise  and  fail  of  commodity  prices  and  interest  rates 
along  the  lines  indicated  above  are  comi:)aratively  narrow  under 
normal  conditions.  Only  in  periods  like  that  which  we  have 
just  passed  through  do  they  become  sufficiently  prominent  to 


The   Trend   of  Bond   Prices  Z7 

attract  widespread  attention.  The  movements  of  commodity 
prices  and  long  time  interest  rates  over  a  period  of  years  are, 
however,  very  wide.  Let  us  take  into  consideration  the  fluc- 
tuations in  the  purchasing  power  of  the  dollar  in  this  country 
since  the  Civil  War,  which  is  our  most  interesting  period. 

The  end  of  the  Civil  War  found  the  United  States  in  a  period 
of  inflation  and  expanded  prosperity,  similar  in  many  respects  to 
the  one  recently  prevailing.  As  a  result,  at  that  time,  as  recently, 
United  States  Government  bonds  sold  on  a  high  yield  basis. 
Our  strongest  first  mortgage  railroad  issues  could  have  been 
bought  to  return  from  7%  to  7^%.  The  inflation  ended  in 
the  extreme  depression  of  1873.  Then  the  country  entered 
a  prolonged  period  of  decline  in  commodity  prices  which  did 
not  culminate  until  the  depression  of  1893  to  1897.  In  the 
period  immediately  following  the  Civil  War,  or  from  1865  to 
1870,  the  pendulum  had  swung  to  the  opposite  extreme  from 
that  prevailing  some  twenty  years  before.  In  the  twenty  or  thirty 
years  following  the  Civil  War  the  pendulum  again  swung  back.  In 
other  words,  the  complete  cycle  of  prices  took  about  fifty  years 
to  complete.  Likewise,  in  1920,  fifty  years  approximately  from 
the  Civil  W^ar  period,  we  were  at  the  extreme  of  high  prices. 

The  Period  of  1865-1895 

In  the  post  Civil  War  period  many  arguments  for  continued 
high  prices,  similar  to  those  recently  used,  prevailed.  It  was 
argued  that,  as  the  war  had  destroyed  so  much  wealth,  the 
country  had  permanently  entered  on  a  period  of  high  prices.  Just 
as  our  circulating  medium  has  now  been  increased  tremendously, 
the  purchasing  power  of  the  dollar  at  that  time  had  been  cut 
down  by  the  same  medium  and  through  the  large  discoveries 
of  gold  just  previous  to  the  Civil  War.  However,  bond  prices 
reached  an  extreme  low  level  about  a  year  after  the  end  of  the 
war.  They  improved  somewhat  in  the  next  five  or  six  years, 
reacting  with  the  financial  collapse  of  1873.  From  that  point 
on,  however,  as  the  broad  cycle  of  declining  prices  developed, 
they  showed  a  persistent  advance  which  did  not  culminate  until 


447469 


38  1 71  vestment   Securities 

the   period   coincident  with   or    immediately   following   the   de- 
pression of  1897. 

The  Period  of  1893-1898 

Tn  the  years  1893  to  1898  the  country  experienced  condi- 
tions just  opposite  to  those  prevailing  in  1865  to  1870.  Owing 
to  extended  deflation  and  over-expansion  the  production  of 
many  portions  of  our  industrial  life  had  exceeded  demand, 
prices  were  very  low,  and  money  was  going  a-begging.  Needless 
to  say  speculative  enterprise  was  at  a  minimum.  Under  such 
conditions  investors  sought  safety  as  a  primary  essential.  As  a 
result,  four  percent  bonds  were  commanding  prices  better  than 
100  cents  on  the  dollar.  Contrast  that  with  the  situation  in  1865- 
1870.  The  growing  difiiculties  of  the  previous  twenty  years  had 
brought  about  many  railroad  reorganizations.  As  a  result,  much 
new  capital  was  needed.  Roads  like  Northern  Pacific,  New  York 
Central,  Norfolk  &  Western,  and  Kansas  City  Southern  were 
fortunately  able  to  take  advantage  of  money  conditions  pre- 
vailing, and  issued  50  and  100  year  bonds  on  a  very  low  return 
basis.  The  New  York  Centra!  3^'s,  issued  in  1897,  were  eagerly 
sought  in  the  next  few^  years  at  10  points  premium  above  their 
face  value,  or  on  a  3%  basis.  Needless  to  say,  under  such  con- 
ditions the  majority  of  corporations  issued  long  term  bonds 
rather  than  short  term  notes.  The  ability  of  many  of  our  rail- 
roads to  sell  such  issues  at  that  time  has  been  a  tremendous 
backlog  for  them  during  the  last  twenty  years  of  achancing 
interest  rates. 

The  Period  of  1900-1920 

Immediately  following  the  improvement  in  industrial  con- 
ditions of  the  early  1900's  this  country  entered  upon  a  prolonged 
industrial  expansion.  Up  to  1906,  this  expansion  had  little 
effect  on  prices.  Since  1906,  however,  commodity  prices  have 
shown  a  continuous  advance  culminating  in  a  rapid  upward 
movement  both  in  the  war  and  post-war  period.  The  recent 
sharp  advance  was  largely  the  result  of  currency  inflation.     As 


The   Trend   of  Bond   Prices  39 

a  result,  the  purchasing  power  of  the  dollar  has  been  cut  in  half. 
During  the  early  years  of  this  period,  bond  prices,  as  viewed  from 
the  long  swing,  showed  little  change,  but  in  the  past  fifteen  years, 
they  have  shown  an  almost  constant  depreciation.  The  ad- 
vance in  commodity  prices  and  interest  rates  during  the  post- 
war period,  has  been  so  rapid  that  prosperity  and  improving 
industrial  conditions  were  entirely  nullified  as  bullish  factors  on 
bond  prices.  As  a  result,  bond  prices  have  shown  a  practically 
steady  depreciation  since  1916  in  face  of  a  general  large  increase 
in  earning  power  behind  them.  The  total  result  of  this  is  that 
bonds  have  once  more  been  brought  back  to  the  levels  prevailing 
in  the  post  Civil  War  period.  Government  bonds  may  be 
bought  on  nearly  a  6%  basis,  while  strong  railroad  issues  have 
been  offered  to  yield  7%. 

The  Chance  of  a  Lifetime 

The  combination  of  a  tremendous  increase  in  demand  for 
goods,  plus  a  large  increase  in  our  circulating  medium,  accom- 
panied by  a  stable  production,  has  given  us  once  more  an  in- 
vestment opportunity  which  the  writer  in  his  work  has  called 
"The  Chance  of  a  Lifetime."  A  simple  study  of  the  history 
of  bond  prices,  as  shown  by  this  chapter,  is  sufficient  to  make  it 
clear  that  an  opportunity  like  the  one  now  prevailing  will  not 
occur  again  during  the  life  of  the  majority  of  business  men. 
Hence,  the  caption  "The  Chance  of  a  Lifetime."  Everyone 
in  a  position  to  do  so  should  take  advantage  of  prevailing  in- 
vestment bargains.  Let  us  then  see  what  issues  are  in  the 
strongest  relative  position. 

Author's  Note:  The  last  two  paragraphs  in  this  chapter  have  been  left 
as  originally  written  in  1920.  This  was  done  so  as  to  bring  out  vividly  the 
completion  of  the  downward  bond  cycle.  As  this  is  written,  in  1923,  bonds 
have  advanced  to  a  level  comparable  with  that  of  1917,  but,  as  can  be  deduced 
from  this  work,  are  still  relatively  low. 


CHAPTER  V 
RAILROAD   BONDS  AS   INVESTMENTS 

Marketability  a  Prime  Consideration 

After  having  established  the  security  of  our  investment  and 
after  having  obtained  as  high  a  return  as  possible  depending  on 
conditions  and  commensurate  with  safety,  our  next  considera- 
tion is  marketability.  This  is  more  than  a  small  item.  All  in- 
dividuals have  many  ups  and  downs.  Although  investments 
are  made  for  income  and  are  thus  considered  permanent,  con- 
ditions often  arise  that  necessitate  immediate  transfer  of  an 
investment,  or  its  liquidation.  It  is  for  this  reason  that  in- 
vestors should  be  careful  to  purchase  only  short  term  notes 
during  periods  of  advancing  commodity  prices  or  declining  bond 
prices,  while,  on  the  other  hand,  during  a  period  of  declining 
commodity  prices,  they  should  persistently  purchase  long  term 
bonds. 

The  New  York  Stock  Exchange  forms  the  broadest  market 
in  probably  the  entire  world  for  both  speculative  and  investment 
securities.  Transactions  in  Liberty  Bonds  amount  to  millions 
daily.  In  addition,  the  average  daily  turn-over  of  bonds, 
exclusive  of  Liberties,  is  probably  around  $7,000,000.  The 
greater  proportion  of  the  bonds  bought  and  sold  on  the  Ex- 
change are  railroad  issues.  Railroad  bonds  have  been  the 
favorite  form  of  investment  in  the  United  States  for  more  than 
fifty  years  and  their  widespread  ownershi]:)  has  brought  about 
a  wide  market.  From  the  standpoint  of  the  marketability, 
there  are  few  investment  issues  superior  to  railroad  bonds. 

Capitalization  of  Our  Railroads 

The  difficulties  of  our  railroads  during  the  war  period  and 
government  operation  of    them   has  centered   study  on   their 


Railroad  Bonds   as   Investments  41 

capitalization  and  values.  Their  capitalization  is  estimated  at 
approximately  twenty  billion  dollars.  About  three-fifths  of 
this  capitalization  is  estimated  to  be  bonds  and  two-fifths  stock. 
For  over  ten  years,  the  proportion  of  bonds  to  stock  has  grown 
steadily.  This  has  been  due  to  two  causes:  first,  the  gradual 
decline  in  railroad  credit  which  has  made  it  impossible  for  any 
but  a  few  of  our  strongest  roads  to  sell  stock  at  one  hundred 
cents  on  the  dollar;  second,  to  the  natural  desire  on  the  part  of 
our  strong  properties  to  finance  at  a  rate  of  interest  lower  than 
the  prevailing  dividend  payments  on  their  stock  issues. 

In  many  quarters,  the  capitalization  of  our  railroads  has 
been  subjected  to  severe  criticism.  It  has  been  charged  that 
organization  expenses,  questionable  assets  and  other  items  have 
been  included  at  full  value  in  capitalization  expenditures. 
However  that  may  be,  the  offsetting  feature  in  the  situation 
has  been  the  continued  advance  in  prices  of  the  past  twenty 
years  coupled  with  the  natural  growth  of  the  territory  served. 
We  have  heard  much  about  the  increase  in  the  assets  behind 
our  industrials  due  to  the  increase  in  the  value  of  their  plants. 
Many  seem  to  forget  that  the  railroads  likewise  have  been  ex- 
periencing an  almost  constant  increase  in  the  value  of  their 
plant.  As  a  result,  there  is  little  question,  even  viewed  from 
the  most  antagonistic  standpoint,  that  railway  bonds  are  today 
fully  covered  by  assets. 

It  will  be  recalled  that  Mr.  Plumb,  author  of  the  Plumb 
Plan  for  operation  of  our  railroads,  stated  that  it  was  his  opinion 
that  the  actual  invested  capital  of  our  railroads  was  approxi- 
mately $12,000,000,000.  This  is  just  about  equal  to  the  par 
value  of  bonds  outstanding.  This  estimate  was  made  from  an 
anti-capitalistic  standpoint,  and  is  considered  absurdly  low  by 
many  financial  authorities. 

The  History  of  Railroad  Development 

In  our  text  on  Railroad  Securities  by  Mr.  Mundy,  the  general 
analysis  of  the  railroad  situation  was  taken  up  in  detail.  Here 
we  will  briefly  discuss  the  advance  and  deterioration  of  railroad 


42  Investment  Securities 

credit.  In  the  period  1895-1900,  a  great  number  of  railroad  re- 
organizations occurred.  This  was  caused  by  years  of  decHning 
prices  which  culminated  in  a  period  of  extreme  business  depression. 
The  reorganizations  at  that  time  of  Atchison,  Northern  Pacific, 
Union  Pacific  and  other  roads  were  so  complete  that  within 
ten  years  an  absolute  transformation  had  taken  place.  These 
systems  became  wonderfully  prosperous.  Their  securities  sold 
at  large  premiums.  Union  Pacific  Common,  starting  from 
below  10  in  the  late  1890's,  sold  at  219  in  1909. 

It  will  be  remembered  that,  while  the  country  was  in  a  period 
of  considerable  industrial  expansion  in  the  first  six  years  of 
this  century,  commodity  prices  rose  relatively  little  up  to  1906. 
With  a  fairly  constant  operating  cost,  owing  to  relatively  favor- 
able prices  for  materials,  fuel  and  labor,  the  gross  and  net  earning 
power  of  our  railroads  increased  tremendously. 

Deterioration  of  Railroad  Credit 

Since  1909,  the  situation  has  been  quite  different.  In  the 
period  from  1906-1912,  indications  developed  that  the  operation 
of  our  railroads  had  not  been  always  conducted  in  the  interests 
of  the  public.  First  one  road  and  then  another  showed  signs 
of  an  inability  to  continue  a  satisfactory  net  earning  power  in 
the  face  of  good  gross  business.  Inter-locking  directorates 
and  other  financial  abuses  were  proving  too  heavy  a  load  for 
railroads  to  carry.  Immediately  after  this  period  came  the 
financial  breakdown  of  roads  like  New  Haven,  Boston  &  Maine, 
Missouri  Pacific,  St.  Louis  &  San  Francisco  and  Rock  Island. 
In  looking  over  these  properties,  it  will  be  appreciated  that  the 
majority,  if  not  all  of  them  are  admirably  located  as  regards 
traffic  possibilities.  Their  downfall  may  be  traced  almost 
directly  to  financial  jugglery. 

These  developments  naturally  reacted  against  the  credit  of 
roads  that  were  honestly  conducted  and  operated  and  which 
have  since  been  so  conducted.  Coincident  with  these  develop- 
ments, however,  there  came  a  permanent  development  of  even 
greater    moment.     Disclosures    of    maladministration    brought 


Railroad  Bonds   as   I  nv  e  stment  s  43 

forth  a  demand  for  closer  supervision  by  the  Interstate  Com- 
merce Commission.  The  Commissioners  felt  they  must  protect 
the  public  absolutely.  This,  under  the  conditions,  naturally 
resulted  in  an  antagonism  to  the  railroads.  At  the  same  time, 
the  prices  of  commodities  showed  a  more  decided  upward  turn, 
which  after  the  opening  of  the  European  War  was  accentuated 
considerably,  thus  increasing  operating  costs  rapidly. 

As  a  result,  in  1915,  1916  and  1917  under  a  period  of  rising 
prices  and  active  business  conditions,  many  of  our  railroads 
failed  to  show  the  same  proportionate  increase  in  net  earning 
power  as  in  previous  periods  of  prosperity.  A  natural  reaction 
was  that  they  failed  to  expand  or  keep  up  with  the  traffic  de- 
mands as  they  had  heretofore,  and  the  physical  condition  of 
both  their  equipment  and  roadbeds  deteriorated.  When, 
therefore,  we  entered  the  War  in  April,  1917,  the  railroad  man- 
agers immediately  combined  in  an  effort  to  unify  the  use  of 
their  equipment  in  an  attempt  to  move  the  tremendous  amount 
of  freight  with  the  tools  that  were  available. 

In  spite  of  herioc  efforts,  this  endeavor  failed,  and  in  De- 
cember, 1917,  the  President  issued  a  proclamation  establishing 
Federal  operation  of  our  railroads.  The  natural  accompani- 
ment of  these  developments  from  the  investors'  standpoint  was 
a  steady  deterioration  of  railroad  credit  and  a  constant  decline 
in  the  prices  of  both  railroad  investment  and  speculative 
securities. 


Federal  Operation 

The  law  which  gave  the  President  control  of  the  railways 
and  instituted  Federal  operation  provided  that  such  operation 
was  to  continue  during  the  war  period  and  for  twenty-one 
months  thereafter  unless  terminated  in  advance  by  the  Presi- 
dent. Federal  operation  continued  until  March  1st,  1920.  In 
many  respects,  both  from  an  operating  and  financial  standpoint, 
it  was  the  most  interesting  period  through  which  our  railroads 
have  ever  passed  and  a  brief  study  of  it  is  absolutely  necessary 
in  any  consideration  of  railroad  bonds  as  investments. 


44  Investment  Securities 

Federal  operation  provided  that  the  government  should 
guarantee  the  railroads  a  net  income  which  was  equal  to  the 
average  net  income  for  the  three  operating  years  1915,  1916 
and  1917.  This  was  quite  a  favorable  offer  as  the  average 
earnings  of  this  three-year  period  were  good.  Federal  operation 
brought  direct  unification.  Cars  were  exchanged  from  one 
road  to  another  without  difficulty.  Freight  was  routed  over 
the  shortest  lines  and  terminals  were  used  as  common  property. 
There  is  no  gainsaying  the  fact  that  the  railroads  as  a  war  factor 
were  one  of  the  most  efficiently  operated  war  machines.  Under 
war  conditions,  however,  the  prices  of  materials,  fuel  and  labor 
rose  rapidly,  as  we  are  all  aware.  As  a  result,  the  government 
was  forced  to  increase  wages  approximately  70%,  and  being 
able  to  increase  rates  only  25%  or  feeling  it  best  that  only  this 
increase  be  made,  a  net  operating  deficit  to  the  government  esti- 
mated at  approximately  $900,000,000  resulted. 

All  during  1918,  the  attention  of  the  Railroad  Administra- 
tion was  directed  to  the  operation  of  the  roads  as  a  war  adjunct. 
Soon  after  the  end  of  the  war,  the  Administration  endeavored 
to  have  control  extended  so  that  it  could  build  up  the  physical  con- 
dition of  the  properties  or  at  least  that  was  the  claim.  Operated 
as  a  war  machine,  the  physical  condition  of  the  roads  became 
somewhat  impaired  and  the  equipment  materially  so.  The 
Administration,  however,  was  unable  to  obtain  an  extension  of 
operation,  and  as  a  result,  it  failed  to  make  large  purchases  of 
necessary  equipment  because  it  naturally  disliked  to  load  down 
the  roads  with  obligations  for  equipment  purchases  immediately 
prior  to  handing  them  back  to  private  control. 

As  a  result,  the  return  to  private  operators  on  March  1st. 
1920,  found  the  railroads  facing  two  difficult  conditions — the 
immediate  necessity  of  large  equipment  purchases  and  a  labor- 
ing body  disgruntled  because  of  the  failure  of  the  Administra- 
tion to  raise  wages  or  lower  living  costs  in  the  last  few  months 
of  control. 

Recent  Legislation 

The  railroads  were  not  handed  back,  however,  without  an 


Railr 0 ad  B  ond s   as   Investments  45 

-effort  being  made  for  a  general  solution  of  the  entire  railroad 
problem.  The  roads  were  handed  back  under  the  Esch-Cummins 
bill,  which  provided  that  the  Federal  guarantee  was  to  be  ex- 
tended for  six  months  until  September  1st,  1920.  In  the  mean- 
time, the  Interstate  Commerce  Commission  was  to  investigate 
the  situation  and  determine  what  rates  should  be  established 
that  vv'ould  allow  the  carriers  as  a  whole  to  earn  an  average 
return  on  their  average  valuation  of  between  5^  and  6%.  After 
careful  deliberation,  the  Commission  granted  increases  in  rates 
averaging  from  25  to  40%.  An  additional  provision  was  that 
any  road  earning  in  excess  of  6%  of  its  valuation  must  divide 
all  excess  50-50  with  the  government. 

This  was  constructive  legislation.  It  did  not  do,  however, 
what  many  individuals  and  investors  claimed.  Statements 
have  been  made  that  the  Esch-Cummins  bill  guarantees  our 
railroads  a  return  of  5|%  on  their  value.  There  is  no  guaran- 
tee. The  days  of  guarantee  passed  September  1st,  1920.  The 
bill  simply  shows  that  a  return  of  5|%  and  6%  on  the  average 
value  invested  in  the  railroad  is  an  essential  return,  and  that 
rates  will  be  allowed,  if  possible,  that  will  in  turn  bring  about  such 
■earning  power.  Actual  return  earned  by  our  railroads  in  1921 
was  less  than  3%  on  the  property  valuation,  in  1922  about  4.4%. 

The  Question  of  Valuations 

It  can  readily  be  seen  that  the  question  of  the  value  behind 
our  railroads  is  to  the  front  more  today  than  ever  before.  For 
a  number  of  years,  the  Interstate  Commerce  Commission  has 
been  making  an  appraisal  of  railroad  properties.  In  allowing 
the  rate  increases,  the  Commission  accepted  a  figure  of  $18,900,- 
000,000  but  this  is  not  permanent.  Certain  tentative  returns 
have  been  given  from  time  to  time.  As  they  came  in,  they 
showed  that  the  replacement  value  of  our  railroads  was  ap- 
proximately equal  to  their  capitalization.  How  the  reproduc- 
tion costs  less  depreciation,  which  will  be  the  ultimate  basis  of 
value,  will  show  up  for  the  purpose  of  rate  making  is  a  question 
for  future  years  to  decide.  What  interests  the  investor  is  that 
the  par  value  of  the  railroad  bonds  are  absolutely  covered  by 


46  Investment  Securities 

asset  values,  even  under  lower  price  levels  than  those  existing 
today.  If,  therefore,  developments  have  brought  about  a  con- 
dition under  which  an  attempt  will  be  made  to  regulate  rates 
to  allow  at  least  a  5|%  annual  return,  the  position  of  the 
bondholder  is  immediately  seen  to  be  stronger  than  it  has  been 
for  some  time. 

Owing  to  the  ability  of  many  of  our  railroad  systems  to 
finance  about  twenty  years  ago  for  a  long  term  of  years  on  a 
very  low  interest  basis,  the  average  interest  rate  of  railroad 
bonds  outstanding  in  this  country  is  about  4|%.  The  average 
price  level  of  railroad  bonds  is  probably  not  over  eighty  per- 
cent of  their  face  value.  This  combination  of  depressed  price 
and  low  average  interest  return,  coupled  with  the  recent  develop- 
ments in  railroad  legislation,  makes  the  position  of  the  bonds 
of  our  strong  railroad  properties  look  particularly  attractive. 

What  of  the  Future  ? 

We  do  not  mean  to  intimate  that  railroad  difficulties  have 
been  solved.  Much  to  the  contrary!  Railroad  bonds  are  so 
protected  by  assets  and  are  so  low  in  price  that  we  do  not  think 
an  entire  elimination  of  difficulties  is  at  all  necessary  in  order  to 
appreciate  the  advantage  of  railroad  bond  investments.  The 
developments  under  recent  legislation  are  bound  to  show  whether 
private  operation  or  government  operation  will  serve  the  public 
best.  The  main  point  is  that  the  essential  character  of  our 
railroads  to  all  industry  is  appreciated.  The  government  has 
an  investment  of  over  $1,000, 000, 000  in  our  railroad  ])roperties. 
The  best  minds  in  the  country  are  studying  the  situation,  and 
whatever  the  future  development,  whether  continued  private 
operation  or  public  operation,  the  position  of  the  railroad  bond- 
holder is  a  strong  one. 

Railroad  Issues  Legal  for  Savings  Banks 

No  discussion  of  railroad  bonds  would  be  com])lete  without 
the  mention  of  the  ]x)sition  that  railroad  bonds  liold  as  legal 
investments  for  trustees  and   sa^'ings  bank  funds.     Just    ])rior 


Railroad   Bonds   as    Investments  47 

to  1900,  the  State  of  New  York  admitted  railroad  bonds  to  its 
list  of  legal  securities.  The  requirements  of  the  larger  states  on 
railroad  bonds,  in  order  for  them  to  be  legal  investments,  are 
that  they  be  secured  by  mortgages  which  are  obligations  of 
railroads  that  have  paid  dividends  of  at  least  4%  for  five 
consecutive  years.  While  these  provisions  have,  of  course, 
immensely  broadened  the  market  for  the  bonds  of  our  strong 
companies,  they  have  not  prevented  them  from  joining  to  an 
equivalent  degree  in  the  general  investment  readjustment  with 
all  other  types  of  issues.  As  a  result,  institutions  or  individuals 
searching  for  investments  legal  for  trustees  are,  under  recent 
railroad  developments,  strongly  attracted  to  our  best  long  term 
railroad  issues  giving,  as  they  do,  an  unprecedented  return. 


CHAPTER  VI 
PUBLIC   UTILITY    BONDS 

Business  Stability 

The  first  requisite  in  any  investment  is  security.  Security 
may  be  said  to  consist  of  two  distinct  divisions,  asset  value  and 
earning  power.  The  bonds  of  a  property  may  be  outstanding 
to  the  amount  of  only  50%  of  the  actual  assets  behind  the 
property  but,  if  the  property  is  not  well  located  or  is  not  pro- 
ductive of  earning  power,  its  value  will  not  long  remain  at  double 
the  bonded  indebtedness.  On  the  other  hand,  as  we  have  seen 
in  our  industrial  life  many  times,  a  property  may  be  so  advan- 
tageously located  and  so  well  managed  that  it  may  earn  many 
times  its  interest  requirements  with  actual  asset  values  little 
more  than  equal  to  its  bonded  indebtedness.  Moreover,  as 
can  be  seen  from  the  above,  earning  power  over  a  series  of 
years  determines  asset  values  to  a  considerable  extent.  A  plant, 
for  example,  is  worth  $100,000  because  it  is  a  going  concern  and 
because  its  earning  power  is  good.  While  there  would  be  no 
change  in  the  actual  assets  if  the  location  of  the  plant  was  poor 
and  it  could  only  operate  at  25%  of  capacity,  the  value  of  its 
property  would  be  considerably  less  than  in  the  first  instance. 

Public  utility  bonds,  perhaps  more  than  any  other  type  of 
investment,  are  protected  by  a  stability  of  both  asset  values 
and  earning  power.  This  is  particularly  true  in  regard  to  gross 
earnings.  The  financial  history  of  this  country  shows  that  irre- 
spective of  prosperity  or  depression  the  demand  for  the  services 
rendered  by  our  public  utilities  has  shown  a  constant  increase. 
This  is  quite  natural  when  we  stop  to  consider,  that  light,  heat, 
transportation,  and  to  a  considerable  extent  telephones,  are 
absolute  necessities,  irrespective  of  whether  an  individual  or 
industry  is  barely  making  both  ends  meet  or  is  making  a  sub- 
stantial profit.     W'ith  the  tremendous   advance  in  the  costs  of 


Public     Utility  B  onds  49 

raw  materials  and  labor  during  the  war  period,  a  somewhat 
different  situation  arose  as  regards  public  utility  net  earn- 
ing power.  This  will  be  discussed  later  in  the  chapter.  Suffice 
it  to  say  now  that  such  a  condition  was  bound  to  be  temporary 
and  that  from  an  earnings  standpoint  the  chief  characteristic 
of  public  utility  operations  is  their  stability. 

Regulation  by  Coniniission 

The  primary  reason  for  stability  in  earning  power  is  constant 
growth  in  population.  Of  secondary  importance,  but  still  of 
considerable  importance,  are  the  conditions  under  which  our 
public  utilities  operate.  Practically  all  our  states,  at  the  present 
time,  have  public  utility  commissions  which  have  judiciary 
control  over  nearly  all  types  of  public  utilities.  These  commis- 
sions protect  the  utilities  themselves  through  franchises  granted 
which,  to  a  considerable  extent,  exclude  competition.  This  is 
just,  because,  if  a  public  utility  is  properly  regulated,  competi- 
tion simply  means  a  duplication  of  plant  and  unnecessary  ex- 
penditure for  which  the  people  must  pay  in  the  end.  Regula- 
tion by  commission  protects  the  investor  to  a  large  extent.  In 
some  states  jurisdiction  extends  to  the  approval  of  security 
issues,  bookkeeping  methods  and  a  general  supervisory  control 
over  both  the  rates  charged  and  service  furnished.  This  has 
prevented  the  development  of  any  considerable  amount  of 
corporate  abuses  in  the  public  utility  field.  Those  that  we 
find   are  largely  developments  of   the   pre-commission   period. 

Commission  control  is  therefore  decidedly  an  added  feature  of 
attractiveness  to  the  investor  in  public  utility  issues.  Let  us 
then,  turn  to  a  brief  discussion  of  individual  fields. 

Gas  Companies 

The  bonds  of  our  strongest  gas  properties  may  be  purchased 
to  give  a  high  return.  Ten  years  ago  gas  properties  represented 
perhaps  the  strongest  public  utility  investment  field.  The 
strong  features  of  gas  properties  are  their  low  maintenance  costs 
and  the  fact  that  they  are  subject  to  practically  no  competition 


50  1 71  vestment   Securities 

from  other  gas  companies  in  the  same  territory.  The  installa- 
tion of  a  new  gas  plant  is  an  expensive  proposition.  Within  the 
past  ten  N^ears,  however,  gas  companies  have  experienced  severe 
competition  from  electric  lighting  properties.  This  has  resulted 
in  driving  them  largely  from  the  lighting  field  so  that  at  the 
present  time  their  chief  source  of  revenue  is  from  cooking  and 
heating.  It  is  much  more  expensive  for  a  gas  property  to  ex- 
pand than  for  an  electric  lighting  property  and  it  seems  probable 
that  competition  between  these  two  industries  will  disappear  in 
favor  of  electric  lighting.  Both  for  cooking  and  heating,  however, 
gas  still  has  the  edge  on  electricity,  on  account  of  lower  costs. 

On  account  of  these  developments  there  has  been  a  notable 
tendency  in  recent  years  for  gas  and  electric  lighting  properties 
to  combine  and  operate  under  one  head.  In  view  of  this  condi- 
tion and  the  developments  noted  above,  it  seems  to  us  that 
investors  would  do  well  to  confine  their  investments  in  com- 
panies furnishing  gas  to  the  properties  combining  both  gas  and 
electricity.  An  illustration  is  the  Consolidated  Gas  Company 
of  New  York  which  not  only  supplies  gas  to  Manhattan  Island, 
but  through  the  New  York  Edison  Company  also  supplies  it 
electricity. 

Electric  Lighting  Companies 

Electric  lighting  companies  have  grown  rapidly  in  the  past 
ten  years  and  their  securities  today  form  a  most  attractive  basis 
for  investment.  Electric  lighting  properties  have  been  much 
more  able  to  withstand  the  advance  in  operating  costs  of  the  war 
period  than  have  gas  companies.  In  recent  years  we  have  seen 
tremendous  improvements  in  the  efficiency  of  electric  lighting 
and  we  can  look  forward  to  still  further  improvements  which 
should  in  turn  further  increase  net  earning  power.  Electric 
lighting  companies  in  large  cities  have  their  wires  under  ground 
and  the  cost  of  maintenance  is  relatively  small.  On  the  other 
hand,  electric  lighting  properties  serving  rural  districts  have 
overhead  wires  which  necessitate  large  charges  for  depreciation 
and  maintenance  but  wlu'ch  is  offset  by  a  considerable  increase 
in  the  rates  received. 


Public     Utility   Bonds  51 

An  electric  lighting  property  should  operate  under  normal 
conditions  for  about  50%  to  60%  of  its  gross  earnings  which  is 
less  than  the  operating  costs  of  gas  properties.  Like  gas  com- 
panies, they  are  immune  to  a  great  degree  from  competition 
within  the  industry  and  as  regards  outside  competition  they 
have  little  to  fear.  A  comparison  of  some  of  our  leading  electric 
lighting  properties  such  as  the  Edison  Electric  Illuminating 
Company  of  Boston,  the  Commonwealth  Edison  of  Chicago, 
the  Brooklyn  Edison  or  the  Cleveland  Electric  Illuminating 
Company,  with  gas  properties  serving  the  same  or  similar 
localities,  will  serve  to  show  the  more  favorable  position  of  the 
electric  lighting  companies. 

Electric  Power  Properties 

One  of  the  most  marked  developments  of  our  recent  period 
of  industrial  expansion  has  been  the  growth  of  electric  power 
properties,  particularly  hydro-electrics.  This  has  been  natural 
for  two  reasons.  As  the  cost  of  fuel  increased  it  was  found 
cheaper  in  many  instances  to  buy  central  station  energy.  In 
the  second  place  a  hydro-electric  is  particularly  well  situated 
in  a  period  of  advancing  prices  for  labor.  As  a  result, 
under  prevailing  conditions,  and  with  the  probability  of  con- 
tinued high  fuel  and  labor  costs  for  some  time,  hydro-electric 
investments  have  become  one  of  the  most  interesting  studies. 
Probably  there  are  few,  if  any,  safer  purchases  than  the  first 
mortgage  bonds  of  fully  developed  hydro-electric  properties. 
These  may  be  bought  to  yield  a  high  return. 

A  hydro-electric  development  is  very  expensive  to  build. 
The  dam  is  costly  and  the  estimate  of  construction  costs  has 
proven,  in  many  cases,  to  be  over-optimistic.  For  example,  the 
Mississippi  River  Power  Company,  one  of  our  largest  hydro- 
electric developments,  issued  $16,000,000  first  mortgage  bonds 
for  construction  purposes  when  the  proposition  was  begun. 
The  company  was  later  forced  to  raise  $26,000,000  and  full 
development  is  not  yet  accomplished.  Once  a  hydro-electric 
has  established  an  ability  to  earn  a  good  rate  of  interest  on  the 


52  Investment  Securities 

cost  of  construction,  however,  there  are  few  more  stable  invest- 
ments. A  study  of  such  properties  as  the  Alabama  Power 
Company,  the  Utah  Power  &  Light  Co.,  the  Connecticut  River 
Power  Company  and  the  Shawinigan  Water  &  Power  Company 
of  Canada  indicate  this  clearly. 

Of  course  hydro-electric  developments  are  bound  to  be 
affected  from  the  standpoint  of  their  gross  earnings  by  fluctua- 
tions in  industrial  prosperity,  but  in  this  regard  it  must  be 
remembered  that  the  purchase  of  power  is  an  operating  need 
and  as  such  is  fairly  stable.  The  average  operating  cost  of  a 
hydro-electric  development  is  low.  The  Mississippi  River 
Power,  which  has  no  steam  plant  whatsoever,  operates  for  less 
than  25%  of  gross.  The  Alabama  Power,  which  is  approximately 
60%  hydro-electric  and  40%  steam  operates  for  about  50%  of 
gross.  With  the  future  as  uncertain  as  at  the  present  time 
companies  which  are  able  to  operate  their  plants  for  such  a  low 
percentage  of  gross  earnings  certainly  should  attract  investors. 

Telephone  Companies 

A  study  of  telephone  companies  in  this  country  really  re- 
solves itself  into  a  discussion  of  the  American  Telephone  & 
Telegraph  Company.  The  development  of  this  property  over 
the  past  20  years  has  shown  a  steady  absorption  of  independent 
properties  and  the  position  of  the  majority  of  the  remaining 
independent  properties  is  such  that  any  discussion  of  telephone 
bonds  should  be  made  in  the  light  of  the  Bell  Telephone  Company 
securities.  The  chief  advantage  of  telephone  securities  is,  it 
seems  to  us,  stability  of  earnings  and  the  fact  that  the  actual 
invested  capital  in  proportion  to  the  user  is  smaller  than  in  any 
other  type  of  public  utility. 

The  disadvantages  are  the  difficulty  of  determining  actual 
assets  behind  the  securities,  obsolescence,  due  to  rapid  improve- 
ment in  telephone  apparatus,  heavy  maintenance  requirements, 
particularly  in  overhead  construction  and  the  necessity  for  con- 
tinued expansion  irregardless  of  whether  such  expansion  is 
profitable  or  un[)rori table.     In  explanation  of  the  latter  let  us 


Public     Utility    Bonds  53 

say  that,  during  the  war  period,  owing  to  a  tremendous  increase 
in  the  price  of  materials  and  labor,  the  value  to  the  company  of 
the  installation  of  new  telephones,  particularly  in  suburban  or 
rural  districts,  was  questionable.  Nevertheless,  telephone  com- 
panies, being  public  servants,  were  compelled  to  continue  in- 
stallation. This  necessity  brings  with  it  constant  expansion 
in  capitalization,  for  a  number  of  years  accomplished  by  stock 
issues,  but  in  war  years  impossible.  As  a  result  we  have  found 
the  funded  indebtedness  of  our  various  Bell  subsidiaries  and  the 
American  Telephone  «&  Telegraph  Company  proper,  increasing 
rapidly.  This,  combined  with  increased  costs  for  maintenance, 
makes  us  feel  that,  unless  the  reversion  to  financing  by  stock 
which  came  in  1921  can  be  continued,  the  bonds  of  our  telephone 
companies  do  not  compare,  as  investments,  with  either  electric 
lighting  or  electric  power  securities. 

Street  Railways 

Any  consideration  of  street  railways  must  be  divided  into 
three  sections;  surface  lines  of  our  larger  cities,  rapid  transit 
lines  such  as  subways  and  elevated  properties,  and  interurbans. 
None  of  these  properties,  with  few  exceptions,  have  available 
securities  that  appeal  to  the  most  conservative  investors.  Owing 
to  custom  and  to  some  extent  past  corporate  abuses,  it  has  been 
difficult  for  our  street  railways  to  obtain  the  same  increases  in 
compensation  that  have  been  obtained  by  other  forms  of  utili- 
ties. As  a  result  more  than  20%  of  the  street  railway  mileage 
of  this  country  is  either  in  the  hands  of  receivers  or  has  been 
torn  up. 

The  most  pressing  necessity  for  street  railways  is  a  decided 
change  in  the  price  level.  Such  a  change,  however,  is  bound  to 
be  slow,  particularly  as  regards  labor.  Labor  represents 
probably  more  than  50%  of  the  operating  costs  of  our  street 
railways.  Average  operating  expenses  of  these  properties 
rose  from  around  70%  to  75%  of  gross  in  the  pre-war  period 
to  levels  ranging  from  85%,  to  100%  during  the  war  and  in 
some  cases  still  higher.  A  study  of  them  therefore  resolves 
itself  into  a  problem  of  a  survival  of  the  fittest. 


54  1 7iv  e  stm  ent  S  ecuritie  s 

A  few  properties,  such  as  the  Detroit  United  Railways^ 
Cleveland  Railways,  and  the  Philadelphia  Rapid  Transit,  on 
account  of  individual  conditions,  have  been  able  to  weather 
the  difficult  post-war  period.  In  the  case  of  the  Detroit  United 
it  has  been  due  to  the  tremendous  expansion  of  the  city,  in 
Cleveland  to  an  agreement  with  the  municipal  authorities 
whereby  the  company  is  allowed  to  charge  sufficient  to  pay  6% 
on  its  stock.  Philadelphia  Rapid  Transit's  success  has  been 
due  to  extremely  good  management,  but  this  company  has  been 
forced  to  appeal  for  increased  fares. 

Rapid  Transit  Lines 

The  street  railway  is  not  only  beset  by  a  tremendous  increase 
in  costs  but  has  also  been  hampered  by  competition  from  motor 
vehicles.  In  both  fields  of  difficulties  we  feel  the  rapid  transit 
lines  of  our  larger  cities  are  favorably  situated.  The  costs  of 
operation  have  not  risen  as  they  have  on  surface  lines  and 
automobile  competition  is  nil.  For  example,  few  men  would 
consider  going  from  the  Battery  on  Manhattan  Island  to  the 
Grand  Central  Station  in  either  a  surface  car  or  an  automobile. 
An  express  train  on  the  subway  would  be  much  more  satisfactory. 

The  New  York  rapid  transit  lines  have  been  held  back  by 
an  operating  agreement  made  with  the  municipality  in  the  pre- 
war period.  Nevertheless,  bearing  in  mind  that  the  develop- 
ment of  our  large  cities  depends  to  a  great  extent  on  the  develop- 
ment of  their  rapid  transit  facilities  we  feel  that  while  no  electric 
railway  bonds,  practically  speaking,  can  be  considered  invest- 
ments at  the  present  time,  the  bonds  of  rapid  transit  lines  look 
attractive  for  investors  willing  to  assume  a  large  risk  for  a 
larger  probable  profit. 

Surface  Lines 

Surface  lines  operating  in  many  of  our  large  cities  also  have 
possibilities.  The  difficulties  here,  besides  increased  costs, 
have  been  due  also  to  a  slowing  down  in  the  rate  of  progress 
due  to  competition  for  the  highway  with  automobiles  and  other 


P  uhlic     V  tility   B  ond  s  55 

vehicles.  In  New  York  City,  for  example,  the  rate  of  progress 
of  a  surface  car  is  estimated  to  be  not  more  than  six  miles  per 
hour.  In  some  of  our  smaller  industrial  centers,  however,  the 
rate  of  progress  is  much  more  rapid.  A  city  like  Chicago,  even, 
gives  a  much  better  showing  and  with  the  increased  industrial 
development  we  are  bound  to  experience,  we  feel  that  there  is 
a  place  for  properties  of  this  character.  It  is  difficult  to  forecast 
developments.  During  the  war  municipal  ownership  looked  prob- 
able. At  the  present  time  a  plan  along  the  service-at-cost  lines 
looks  more  probable.  The  properties  perform  a  needed  function. 
They  have  a  fixed  investment  and  it  is  only  natural  to  expect 
that  in  years  to  come  they  will  be  allowed  to  earn  a  fair  return 
on  the  capital  invested. 

Interurbans 

This  class  of  street  railway  has  a  problematical  future,, 
particularly  in  the  East.  High  speed  interurbans  in  many 
places  parallel  steam  lines  and  with  the  coming  electrification 
of  steam  lines  the  future  is  questionable.  Where  they  act  as 
feeders  they  are  paralleled,  in  the  East,  by  good  roads,  and  it  is 
in  this  field  of  electrical  development  that  the  severest  competi- 
tion with  the  automobile  has  developed.  The  cost  of  mainte- 
nance of  such  properties  is  relatively  heavy.  The  users  are  not 
industrial  workers,  we  believe,  in  the  majority  of  cases,  and 
this  end  of  the  street  railway  industry  certainly  seems,  in  view 
of  recent  developments,  to  have  been  over-boomed  in  the  past 
fifteen  years.  The  situation  in  the  West  is  not  as  mixed  because 
in  many  cases  the  interurbans  act  as  carriers  of  freight  as  well 
as  passengers  and  are  not  paralleled  by  roads  of  good  construc- 
tion. They  operate  over  private  rights  of  way  and  attain  a 
higher  speed  than  eastern  interurbans.  Nevertheless  the  entire 
interurban  industry  is  in  a  difficult  position  and  we  feel  that 
investors  would  do  well  to  confine  purchases  to  other  fields. 

The  Future 

All  types  of  public  utilities,  irrespective  of  whether  rendered 
assistance  by  utility  commissions  or  not,  have  been   through  a 


56  Investment  Securities 

difficult  period  in  the  last  five  years.  It  is  very  hard  to  point 
out  any  utility  companies  that  have  been  allowed  to  increase  the 
prices  for  their  product  in  the  same  ratio  as  average  manufac- 
turing prices  have  been  increased.  Those  that  have  been  able 
to  withstand  such  conditions  and  continue  to  pay  a  fair  rate  of 
return  on  the  stocks  which  follow  their  funded  indebtedness, 
certainly  have  a  bright  future.  While  prevailing  costs  will 
drop  slowly,  a  long  pull  study  of  the  future  suggests  certainly 
that  the  most  difficult  period  of  utility  operation  is  behind  us. 
If,  therefore,  we  concentrate  on  utility  securities  that  seem 'to 
have  possibilities  of  tremendous  development  from  the  stand- 
point of  gross  earnings,  such  as  electric  lighting  companies, 
electrical  power  companies,  or  rapid  transit  properties,  we  will 
have  the  bases  for  some  extraordinarily  attractive  investments 
when  even  lower  wage  levels  and  lower  prices  for  materials  and 
fuel  allow  a  wider  margin  of  net  earning  power  in  relation  to 
gross  revenue. 


CHAPTER  VII 
INDUSTRIAL   BONDS 

History 

Industrial  companies,  more  than  any  other  class  of  enterprise 
in  this  country,  have  been  able  to  finance  for  a  number  of  years 
by  means  of  stock  issues  and  in  many  cases  by  common  stock 
issues.  The  factors  that  have  brought  about  difficult  operating 
conditions  among  utilities  and  rails  have  been  very  favorable 
to  industrials.  During  the  period  of  advancing  prices,  selling 
prices  that  are  flexible  tended  to  increase  faster  than  operating 
costs.  There  is  no  restraint  on  increasing  industrial  selling 
prices  except  the  law  of  supply  and  demand.  As  a  result, 
while  the  net  earning  power  of  rails  and  utilities  has  been  re- 
stricted, the  net  earning  power  of  industrials  was  expanded  to  a 
tremendous  degree  and  the  common  stocks  of  many  companies, 
formerly  selling  below  $50  a  share,  have  sold  considerably  above 
their  par  value.  This  has  allowed  properties  in  need  of  additional 
working  capital,  or  desiring  to  expand,  to  sell  additional  common 
stock  to  stockholders  at  100  cents  on  the  dollar.  This  condition, 
however,  is  the  consummation  of  years  of  difficult  operations 
and  slow  development. 

Industrials  as  a  class  are  noted  for  conditions  quite  the 
opposite  of  public  utilities.  Stability  of  earning  power  is  not 
their  strong  fort.  Their  earning  power  expands  greatly  in 
periods  of  prosperity  but  contracts  just  as  quickly  in  periods  of 
depression.  The  industry  as  a  whole  has,  in  past  years  been 
largely  speculative.  Until  the  relatively  recent  past,  it  has 
been  difficult  to  induce  investors  to  enter  industrial  enterprises. 
The  field  has  been  the  mecca  of  speculators.  Furthermore,  as 
noted  above,  after  the  field  became  fully  established,  the  advent 
of  tremendous  prosperity  removed  necessity  of  widespread 
financing  through  bond  issues.     As  a  result,  in  proportion  to  the 


58  Investment  Securities 

"business  and  output,  we  have  fewer  attractive  industrial  bonds 
today  than  any  other  class. 

Prevailing  Types 

The  industrial  issues  of  long  standing  that  are  available, 
however,  and  we  are  now  speaking  of  long  term  industrial  issues, 
are  very  high  grade.  The  mortgages  under  which  industrial 
bonds  are  issued  are  by  no  means  as  complex  as  railroad  mort- 
gages or  even  those  of  public  utilities.  Industrial  bonds  are 
mostly  of  two  classes,  either  first  mortgages  or  debentures.  In 
many  cases  where  the  bonds  are  debentures  they  are  not  pre- 
ceded by  any  mortgage  on  the  property.  This  is  the  case  with 
the  General  Electric  issues,  for  example.  It  makes  them  in 
reality  a  first  lien  upon  the  assets  of  the  organization.  First 
mortgage  bonds  where  available,  are  in  a  very  strong  position 
and  irrespective  of  periods  of  depression  or  prosperity  our 
industrial  development  has  now  reached  a  stage  where  the 
earning  power  of  our  stronger  properties  should  constantly  be 
largely  in  excess  of  their  mortgage  interest  requirements.  For 
example,  such  bonds  as  the  American  Smelting  First  Mortgage 
5's,  1947,  the  Armour  &  Company  First  4^'s,  1939,  are  types 
in  question. 

Convertible  Issues 

An  attractive  medium  of  financing  of  some  industrial  com- 
panies, that  have  not  become  sufficiently  seasoned  through  con- 
tinued prosperity,  is  by  convertible  issues.  Convertible  issues 
of  this  type  are  made  convertible  into  the  stock  at  some  future 
date  and  at  a  price  higher  than  prevailing  levels.  The  idea  of 
the  company  is  that,  as  development  proceeds,  the  stock  will 
become  more  valuable.  In  the  meantime  it  ofi'ers,  in  return 
for  money  to  finance  the  enterprise,  not  only  a  fixed  rate  of 
interest  but  also  the  possibility  of  sharing  in  the  future  develop- 
ment above  spoken  of.  When  such  bonds  are  protected  by  a 
good  margin  of  assets  they  form  a  very  attractive  investment 
and  during  the  recent  industrial  prosperity  have  proven  quite 
profitable.  A  case  in  point  is  (he  Lackawanna  Steel  Conver- 
tible 5's.     Other  con\xrLible  issues  that  illustrate  the  situation 


Industrial  Bonds  59 

referred  to  above  are  the  Wilson  Convertible  7^'s  of  1931.  The 
position  of  Wilson  &  Company  is  not  quite  as  stable  as  that  of 
Armour  or  Swift.  By  issuing  convertible  bonds  it  was  able  to 
finance  with  a  debenture  issue.  The  Chile  Copper  Company, 
another  industrial  that  is  largely  in  the  development  stage,  has 
been  able  to  do  its  financing  through  the  means  of  convertible 
bonds  that  may  be  exchangeable  at  some  future  date  into  the 
stock  at  $35  a  share. 

Recent  Financing 

With  the  inflation  that  followed  the  war  came  another 
change  in  industrial  financing.  The  older  stable  properties 
were  well  supplied  with  capital  and  had  husbanded  their  re- 
sources derived  from  war  prosperity.  The  tremendous  indus- 
trial expansion,  however,  brought  into  existance  innumerable 
smaller  industrial  properties.  The  Central  West  has  been 
particularly  productive  of  this  type  of  industrial.  Some  of 
them  were  combinations  formed,  in  the  period  of  inflation 
following  the  war,  from  close  corporations.  Other  smaller 
properties  that  entered  the  market  for  funds  were  those  that 
distributed  the  profits  of  the  war  period  quite  lavishly.  With 
the  restriction  of  credit  the  carrying  of  large  inventories  became 
difficult  and  the  appeal  for  money  resulted. 

In  most  all  instances  this  financing  has  been  accomplished 
in  the  form  of  funded  indebtedness  by  the  means  of  shorter  term 
bonds.  In  some  cases  these  bonds  were  convertible  into  long 
term  bonds  at  a  later  date;  in  other  cases  into  preferred  or 
common  stocks.  In  considering  such  issues  two  things  must 
be  kept  constantly  in  mind.  In  case  of  new  consolidations 
itniust  be  remembered  that  any  appraisal  of  properties 
made  under  prices  prevailing  during  the  period  of  inflation 
would  mean  high  values  which  would  probably  not  remain 
over  a  period  of  years.  Again  the  financing  of  inventories 
during  a  period  of  declining  prices  is  bound  to  be  difficult. 
It  is  for  this  reason  that  the  old  seasoned  properties  have  been 
so  conservative  in  dividend  payments.     A  new  industrial  con- 


60  Investment    Securities 

solidation,  formed  during  a  period  of  high  prices,  or  an  industrial 
that  has  been  lavish  in  dividends  during  such  a  period,  is  bound 
to  experience  financing  difificulties  during  any  deflationary 
period.  For  that  reason  it  does  not  seem  to  us  that  industrial 
issues  of  this  type  can  compare  as  investments  with  the  issues 
of  corporations  that  have  been  through  difficulties  over  the 
past  ten  years. 

Industrial  Preferred  Stocks 

Owing  to  the  ability  to  count  money  received  from  the  sale 
of  preferred  issues  as  invested  capital,  and  owing  to  the  fact 
that  the  income  received  from  preferred  stocks  is  not  subject 
to  the  normal  tax,  this  form  of  financing  has  become  very  at- 
tractive to  industrials.  Preferred  stocks  to  attain  the  character- 
istics of  bonds  in  any  degree  must  be  surrounded  by  stringent 
restrictions.  Even  then  they  cannot  be  given  the  right  of 
foreclosure.  Furthermore  the  permanent  value  of  many  re- 
strictions placed  on  preferred  stocks  is  somewhat  questionable. 

Preferred  stock  flotations  by  industrials  seem  to  come  and 
go  in  waves.  We  experienced  a  preferred  stock  flotation  boom 
in  1912,  another  one  in  1919  to  1920.  Preferred  stockholders 
of  the  offerings  of  1912  experienced  decided  losses  in  investments 
in  the  years  that  followed.  Typical  weaker  preferred  stock 
issues  of  that  period  were  the  Advance-Rumely  Preferred,  the 
International  Agricultural  Chemical  Preferred,  and  even  Good- 
rich Preferred.  Offerings  of  this  type  have  been  duplicated 
many  times  in  the  recent  past. 

The  value  of  seasoning  in  industrial  preferred  stocks  is 
more  marked  than  perhaps  in  any  other  type  of  investment. 
Consider  the  course  of  American  Sugar  Refining  Preferred. 
This  is  one  of  the  best  industrial  preferred  stocks  that  has  ever 
been  offered  to  investors.  It  was  put  out  in  1891.  It  has  paid 
7%  dividends  continuously  since.  In  spite  of  that  fact,  in  the 
panic  of  1893  it  sold  at  66^;  in  the  depression  of  1897  at  79f. 
By  1903,  however,  the  stock  had  become  securely  lodged  in 
the  hands  of  investors.  As  a  result,  in  that  depression  it  failed 
to  go  below  111.     In  1907  its  low  point  was  106,  in  1914,  107|,  and 


Industrial  Bonds  61 

in  1917,  106.  Industrial  preferred  stocks  of  this  type  are 
always  on  the  bargain  counter  in  periods  of  inflation,  due  to 
very  high  prices  for  goods  and  money,  or  in  other  words  low 
purchasing  power  of  income.  Investors,  therefore,  desiring 
industrial  preferred  stock  investments  should  confine  purchases 
to  such  issues  rather  than  to  the  newer  unseasoned  offerings. 

Author's  Note:  This  last  section  "Industrial  Preferred  Stocks"  written 
in  1920  has  not  been  changed  in  revision.  I  believe  it  will  prove  of  greater 
value  to  investors  left  as  it  is.  The  depression  of  1921  certainly  saw  the 
developments  promised  among  the  newer  industrial  preferred  stock  flotations 
of  1919-20.  It  is  a  situation  that  will  recur  frequently  over  the  next 
twenty  years. 


CHAPTER  VIII 
GOVERNMENT   BONDS 


Characteristics 


The  characteristics  of  government  bonds  were  discussed 
briefly  in  the  chapter  "Classification  of  Bonds."  There  we 
showed  that  the  real  asset  behind  government  bonds  is  the 
good -will  of  the  people  rather  than  the  combined  property 
values. 

There  is,  of  course,  considerable  connection  between  the 
asset  values  of  a  nation  and  the  good-will  of  its  people.  An 
impoverished  nation  with  a  heavy  debt  would  be  forced  to  tax 
its  people  so  tremendously  that  it  would  quickly  lose  their 
good-will  and  be  forced  to  ultimate  repudiation. 

In  considering  United  States  Government  bonds,  we  have 
to  give  only  passing  consideration  to  actual  asset  values.  We 
are  all  aware  they  are  tremendous.  The  real  strength  behind' 
United  States  Government  bonds,  the  factor  that  makes  them 
sell  on  a  higher  plane  than  any  other  government  issues  is  the 
united  support  of  the  government  by  the  people  and  their 
willingness  to  fight  in  its  behalf.  In  other  words,  the  extraor- 
dinary values  behind  our  bonds  are  really  a  reflection  of  the 
tremendous  opportunities  the  country  offers  to  every  individual. 

Wealth,  Debt  and  Income 

In  considering  asset  values,  however,  here  again,  the  United 
States  stands  pre-eminent.  Prior  to  our  entrance  into  the  war, 
our  national  debt  was  roughly  $1,000,000,000.  During  the  war, 
$16,937,436,850  bonds  were  issued,  also  approximately  $4,500,- 
000,000  notes.  Altogether,  our  total  debt  at  the  present  time, 
1922,  is  roughly  $24,000,000,000.  Our  wealth  is  estimated  at 
from  $300,000,000,000  to  $325,000,000,000;  our  annual  income 


Cover 71  ment  Bonds  63 

at  from  $50,000,000,000  to  $55,000,000,000.  Hence,  in  spite  of 
the  tremendous  increase  in  government  bonds  outstanding, 
our  annual  income  is  still  considerably  more  than  twice  our 
total  debt.  At  an  average  rate  of  4|%,  the  annual  interest 
payments  on  present  government  debt  would  be  about  $1,000,- 
000,000. 

In  other  words,  one-fiftieth,  roughly,  of  our  total  yearly 
income  must  go  toward  paying  interest  on  our  debt,  or  two 
cents  out  of  every  dollar.  Considering  what  we  have  beea 
through  and  comparing  our  position  with  that  of  foreign  nations, 
which  we  will  outline,  the  tremendously  strong  position  of  our 
nation  is  apparent. 

Liberty  and  Victory  Loan  Issues 

While  the  United  States  Government  has  some  old  long- 
term,  low-interest  bearing  bonds  outstanding,  when  we  speak 
of  government  obligations  at  the  present  time,  from  an  in- 
vestor's standpoint,  we  refer  to  the  Liberty  and  Victory  loan 
bonds. 

r  We  are  all  familiar  with  the  purposes  for  which  these  bonds 
were  put  out.  They  are  all  obtainable  in  small  denominations. 
They  form,  without  a  doubt,  the  safest  investment  in  the  entire 
world.  The  table  on  the  following  page  is  more  descriptive  of 
them  than  any  narrative  could  be.  Considering  the  outlook 
for  long  term  investments,  the  Liberty  4|'s  maturing  in  1938 
and  1942  look  very  attractive.  Quotations  on  these  bonds  are 
given  daily  in  our  financial  publications,  activity  in  them  on 
the  New  York  .Stock  Exchange  is  tremendous.  They  have  the 
broadest  market  of  any  security  in  the  world. 

Their  position  in  regard  to  taxation  is  graphically  explained 
in  the  table.  It  is  possible  for  an  individual,  under  correct 
conditions,  to  hold  $160,000  Liberty  4j's  exempt  from  taxation. 
LTnder  the  rulings  of  the  Treasury  Department,  it  is  possible 
for  anyone  to  go  into  the  market  and  purchase  up  to  $35,000, 
irrespective  of  subscription  to  any  of  the  loans,  and  hold  them 
tax-exempt  for  a  considerable  period. 


'64 


1 71  vestment  Securities 


UNITED  STATES  LIBERTY 

The  principal  characteristics  of  the  ten  different  issues 


3Ms 

4s 

1st  Liberty  Loan 

1st  Liberty  Loan  2d    Liberty   Loan 

1st  Liberty 

3Ks 

— Converted  4s                   4s 

Loan — Con- 

15-30 Year  Bonds 

15-30  Year  Bonds     10-25  Year  Bonds 

verted  4Xs 

1947 

1947                             1942 

*IssueofMay9, 

191S.      15-30 

Year  Bonds 

1947 

■Callable 

Redeemable       at 

Redeemable       at     Redeemable       at 

Redeemable  at 

For 

government's 

government's       ,       government's 

government's 

Payment 

option     on     or 

option     on     or  '       option     on     or 

option  on  or 

after   June    15, 

after    June    15,         after   Nov.    15, 

after  June  15, 

1932. 

1932. 

1927. 

1932. 

Interest 

June      15th     and 

June     15th     and 

May     15  th      and 

June  ISth  and 

Payments 

Dec.  15th. 

Dec.  15th. 

Nov.  15th. 

Dec.  15th. 

■Conversion 

Convertible     into 

Convertible     into  ^  Convertible     into 

Not  convertible 

Privilege 

any  higher  rate 

the  First   Con-  i       Second  Conver- 

into    any    fu- 

bond issued  dur- 

verted   4Xs    if  i       verted    4Xs    if 

ture  issue. 

ing      the      war 

application      is  :       application      is 

(except)     short 

made        before 

made        before 

term          loans) 

Nov.  9,  1918. 

Nov.  9.  1918. 

within             six 

This    privilege   to 

This    privilege    to 

months       from 

convert          has 

convert          has 

date  of  the  issue 

been    extended 

been    extended 

of   such    higher 

and  renewed. 

and  renewed. 

rate  bond.   The 

date  of  the  ter- 

mination of  the 

war     shall     be 

date    fbced    by 

proclamation  of 

the  President 

Taxation 

Exempt   from   all 

See  B,  C.  E  and  F. 

See  B,  C,  E  and  F. 

See  A,  B,  C,  E 

Feature 

taxes       (except 
estate    and    in- 
heritance taxes). 

and  F. 

A. — Bonds  owned  continuously  for  at  least  six  months  prior  to  one's  death  are  acceptabl  e 
at  par  and  accrued  interest  in  payment  of  any  estate  and  inheritance  taxes  imposed  by  the 
United  States  under  any  present  or  future  law. 

B. — Exempt  from  state  and  local  taxes  and  from  normal  income  tax.  Subject  to  state, 
inheritance,  super-tax,  excess  and  war-profits  tax  on  all  incomes  and  earnings  above  the  normal 
exemption;  incomes  from  holdings  of  $5,000  bonds  are  tax  e-xempt  except  for  estate  and  in- 
heritance taxes. 

C. — In  addition  income  from  not  more  than  $45,000  bonds  of  this  issue  or  a  small  amount 
not  exceeding  \yi  times  the  amount  of  the  Fourth  Liberty  Bonds  held  by  the  owner  is  exempt 
until  two  years  after  the  war  from  surtaxes,  excess  and  war-profits  taxes,  provided  said  Fourth 
Loan  Bonds  were  originally  subscribed  for  and  have  been  continuously  owned  by  the  tax  payer 
up  to  the  date  of  his  tax  return. 

D. — In  addition  to  exemption  under  B,  interest  on  not  to  exceed  $30,000  bonds  of  this 
•issue  is  exempt  until  two  years  after  the  war  from  surtaxes,  excess  and  war-profits  taxes  when 
owned  by  one  individual,  partnership,  corporation  or  association. 

E. — In  addition  to  the  tax  exemption  under  B,  income  received  on  and  after  January  1, 
1919,  on  not  to  exceed  $30,000  bonds  in  the  aggregate  is  exempt  until  the  expiration  of  five 
years  after  the  war  from  surtaxes,  excess  and  war-profits  taxes. 


Government  Bonds 


65 


AND  VICTORY  LOAN  BONDS 

of  Liberty  and  Victory  Loans  are  set  forth  below. 


4Ms 

3%s  &  4Ms- 

let    Liberty 

2d   Liberty   Loan 

3d   Liberty  Loan 

4tli  Liberty  Loan 

Victory  Lib- 

Loan— 2d  Con- 

—Converted  4Xs 

4Xs 

4^8 

erty  Loan 

verted  4J<s 

10-33  Year  Bonds 

10  Year  Bonds 

15-20  Year  Bonds 

3-4  Year  Notes 

*Issue  of  Oct.  24, 

1942 

1928 

1938 

1923 

1918 

16-30  Year  Bonds 

1947 

Redeemable    at 

Redeemable       at 

Not      redeemable 

Redeemable        at 

Redeemable  at 

government's 

government's 

until  maturity. 

government's 

government's 

option   on   or 

option     on     or 

option     on     or 

option  on  or 

after  June  15, 

after   Nov.    15, 

after    Oct.    15, 

after  June  15, 

1932. 

1927. 

1933. 

1922,  upon 
not  less  than 
four  months' 
notice. 

June    15th    and 

May      15  th     and 

September      15th 

April     15th     and 

December  15th 

Dec.  15th. 

Nov.  15th. 

and  March  15th. 

October  15th. 

and          June 

15th. 

Not  convertible 

Not      convertible 

Not      convertible 

Not      convertible 

The    3Ks   and 

into  any  future 

into  any  future 

into  any  future 

into  any  future 

4J^s  are  con- 

issue. 

issue. 

issue. 

issue. 

vertible  and 
reconverti  b  le 
each  into  the 
other  after 
July  IS,  1919, 
but  before 
maturity  or 
call  for  re- 
demption. 

See  A,  B,  D,  E 

See  A,  B,  C,  Eand 

SeeA,  B,  C,  Eand 

See  A,  B,  D,  E  and 

See  G  and  H. 

and  F. 

F. 

F. 

F. 

See  Note  A  as 
regards  4K's. 

F. — In  addition  to  the  tax  exemption  under  E,  income  received  on  and  after  January  1, 
1919,  on  not  to  exceed  $20,000  bonds  in  the  aggregate  is  exempt  from  surtaxes,  excess  and 
war-profits  taxes,  extending  through  the  life  of  the  Victory  Notes,  provided  such  bonds  do 
not  exceed  three  times  the  principal  amount  of  Notes  of  the  Victory  Liberty  Loan  originally 
subscribed  for  by  such  owner  and  still  held  by  him  at  the  date  of  his  tax  return. 

G. — The  3J<s  are  exempt  both  as  to  principal  and  interest  from  all  taxation  (except 
estate  and  inheritance  taxes)  now  or  hereafter  imposed  by  the  United  States,  any  State  or 
any  of  the  possessions  of  the  United  States,  or  by  any  local  taxing  authority. 

H. — The  4J^s  are  exempt  both  as  to  principal  and  interest  from  all  taxation  now  or 
hereafter  imposed  by  the  United  States,  any  State,  or  any  of  the  possessions  of  the  United 
States,  or  by  any  local  taxing  authority,  except  estate  or  inheritance  taxes,  and  graduated 
additional  income  taxes,  commonly  known  as  surtaxes,  and  excess  profits  and  war-profits 
taxes,  now  or  hereafter  imposed  by  the  United  States,  upon  the  income  or  profits  of  individuals, 
partnerships,  associations  or  corporations. 

*The  two  issues  of  First  Converted  4>i's  differ  only  to  the  extent  that  the  issue  of  Octo- 
ber 24th  is  tax  exempt  as  to  the  interest  on  not  to  exceed  $30,000  bonds  regardless  of  one's 
subscription  to  the  Fourth  Loan,  whereas  the  issue  of  May  9th  is  tax  exempt  as  to  the  interest 
on  not  to  exceed  $45,000  bonds  in  connection  with  one's  subscription  to  the  Fourth  Loan. 


-66  1 71  vestment  Securities 

The  Market  Action  of  Liberty  Bonds 

The  majority  of  us  holding  Liberty  Bonds  subscribed  for 
them.  The  more  fortunate  have  been  able  to  purchase  on 
declines,  but  many  hold  the  ones  originally  purchased  at  par. 
Naturally  the  decline  of  1919-1920  was  disturbing.  A  brief 
discussion  of  the  causes  should  be  interesting. 

To  begin  with,  it  must  be  remembered  that,  even  at  the 
beginning  of  the  war,  the  government  did  not  attempt  to 
borrow  at  the  going  rate  of  interest.  The  first  issue,  the  non- 
taxable 3|'s  undoubtedly  approximately  reflected  the  credit  of 
the  government  on  a  non-taxable  basis.  A  4%  bond  at  par, 
taxable  to  a  great  extent,  as  the  First  4%  issue  was,  was  in  no 
wise  a  true  reflection  of  credit  conditions.  Patriotism  played 
a  large  part  in  the  sale  of  this  loan  and  continued  to  play  a  large 
part  in  future  loans.  The  progressive  increase  to  4j%  and  then 
4f  %  for  a  short  term  note  did  not  reflect  the  increasing  interest 
rates  in  other  securities. 

At  the  end  of  the  war,  many  who  had  purchased  government 
bonds  wrongly  felt  that  their  obligation  had  ceased,  and  liqui- 
dated. This  was  followed  by  a  period  of  inflation,  in  which  a 
great  many  people  thought  a  good  deal  more  of  spending  than 
saving,  and  changed  their  Liberty  bonds  into  hats,  suits  or 
phonographs. 

In  addition  to  these  conditions,  the  Federal  Reserve  Banks 
had,  during  the  war,  given  all  the  assistance  possible  to  the 
government  in  aiding  the  distribution  of  its  bonds.  It  had 
purposely  kept  its  rediscount  rates  at  a  level  equivalent  to,  or 
below,  the  rates  on  government  issues.  Many  will  remember 
the  slogan  "Borrow  and  Buy."  Subsequent  events  questioned 
the  wisdom  of  that  advice. 

At  any  rate,  the  end  of  the  war  found  a  tremendous  amount 
of  government  bonds  lodged  in  the  Federal  Reserve  Banks, 
which  bonds  had  been  used  for  rediscount  purposes  —  that  is 
people  had  taken  the  bonds  to  the  banks  and  had  borrowed  on 
them,  the  banks  in  turn  re-borrowing  with  the  Federal  Reserve 
System. 


G  ov  er  nmen  t  B  0  nd  s  67 

When  the  ckingerousness  of  the  inflation  that  took  place  in 
1919  was  appreciated,  the  Federal  Reserve  Board  successively 
raised  its  rediscount  rate.  Cheap  credit,  meaning  easy  borrow- 
ing, lends  itself  to  an  enlarged  purchasing,  competitive  bidding 
for  goods,  and  thus  inflation.  A  progressive  increase  in  interest 
rates,  or  making  credit  difficult  to  obtain,  has  the  opposite 
efi"ect.  It  makes  expansion  difficult  and  brings  about 
deflation. 

This  was  what  was  necessary  and  what  the  Reserve  Board 
was  working  for,  but  in  doing  it,  it  naturally  brought  about 
widespread  liquidation  of  Liberty  Bonds  as  the  cost  of  borrowing 
on  them  became  almost  prohibiti\'e.  The  difficulties  of  people 
who  had  borrowed,  however,  brought  a  tremendous  oppor- 
tunity for  people  with  ready  cash. 

The  Future 

As  noted  above,  the  change  from  inflation  in  this  country  to 
deflation  took  place  in  the  winter  of  1919-20.  Over  a  series 
of  years,  we  can  undoubtedh^  look  forward  to  lower  commodity 
prices,  which  will,  in  turn,  bring  low'er  interest  rates.  With  the 
high  credit  of  the  United  States  Government,  the  holders  of 
Liberty  Bonds  were  the  first  to  feel  the  favorable  effects  from 
such  developments.  It  is  not  too  much  to  expect  that  within  a 
comparatively  short  time,  the  price  of  Liberty  4|'s  will  go 
above  par.  With  our  present  wealth,  income  and  debt,  a 
credit  basis  of  4%  for  the  United  States  Government  under 
normal  investment  conditions  is  entirely  probable. 

The  opportunity  offered  and  probable  future  of  United 
States  Government  bonds  can  be  appreciated  by  considering  the 
trend  of  British  Consols  in  the  years  following  the  Napoleonic 
Wars.  The  position  of  Great  Britain  at  that  time  was  nowhere 
near  as  strong  as  ours  today.  British  consols  were  not  helped 
by  an  approaching  maturity.  Nevertheless,  they  advanced 
approximately  30%  in  value  in  a  comparatively  few  years.  We 
feel,  therefore,  that  the  expectation  of  similar  developments  in 
United  States  bonds  is  not  at  all  over-optimistic. 


68  Investment  Securities 

Position  of  Foreign  Governments 

With  the  tremendous  financing  of  the  Great  War,  the  question 
of  foreign  investments  has  become  of  prime  importance  to  the 
United  States  investor.  The  broadening  of  our  investment  field 
is  bound  to  be  of  distinct  benefit  to  the  nation.  As  holders  of 
European  securities,  we  would  yearly  receive  large  interest 
payments,  thus  automatically  swinging  the  exchange  situation 
in  our  favor. 

Nevertheless,  such  investments  must  be  considered  and 
approached  purely  from  the  business  standpoint,  and  are  of 
no  value  if  not  sound.  Any  investment  pre-supposes  a  degree 
of  safety  sufficient  to  give  uninterrupted  income  over  a  series 
of  years.  A  consideration  of  an  investment  in  European  Govern- 
ment bonds  must  be  based  on  the  same  grounds.  We  wish, 
therefore,  to  discuss  the  position  of  the  foreign  nations  particu- 
larly as  compared  with  our  own  position  and  to  a  lesser  degree 
as  compared  with  each  other. 

As  the  values  behind  government  obligations  consists  of 
the  united  support  of  the  people,  as  we  have  shown,  and  as  this 
good  will  and  support  is  closely  bound  up  with  the  wealth, 
debt  and  income  of  the  nation,  let  us  consider  briefly  these 
conditions. 

Wealth  and  Income  —  a  Comparison 

The  table  shown  on  the  opposite  page  serves  to  give  this 
information  in  a  graphic  form.  We  have  reduced  the  debt  in 
all  cases  to  a  per  capita  basis.  This  gives  a  real  comparison. 
The  actual  debt  of  the  nations  is,  of  course,  changing  constantly, 
but  the  figures  given,  based  on  conditions  late  in  1919,  are 
valuable  for  comparative  purposes. 

It  goes  without  saying  that  the  situation  of  the  United 
States  is  sounder  than  that  of  any  other  nation,  from  every 
standpoint.  Perhaps  the  outstanding  feature  of  the  table  is 
the  situation  of  France.  Its  debt  per  capita  exceeds  that  of  the 
two  Central  Empires.  While  its  debt  is  not  as  large  a  percentage 
of  its  national  wealth  as  is  that  of  Great  Britain,  Italy  or  Austria, 


Government  Bonds 


69 


the  per  cent  of  debt  charges  to  national  income,  which  is  really 
more  important,  is  the  largest  of  any  nation. 

PUBLIC   DEBTS   OF  VARIOUS  NATIONS 

Debt  Debt 

Debt               Debt  charges  charges 

per  capita       per  capita  per  capita  per  capita 

pre-war           recently  pre-war  recently 

United  States   $11.33           $249.  s$0.22  $8.40 

Great  Britain 75.03             820.  2.60  31.00 

France   166.                 770.  6.35  49.00 

Italy 82.55             410.  2.80  15.75 

Belgium 94.25             250.  3.25  11.15 

Germany 17.20             600.  0.62  33. 

Austria 85.                 555.  3.25  20.50 

Debt  as        Debt  as  Debt  charges  Debt  charges 

%  of  nat.     %  of  nat.  as  %  of  as  %  of 

wealth           wealth  nat.  income  nat.  income 

pre-war       recently  pre-war  recently 

United  States  0.60               13.  0.07  2.55 

Great  Britain 5.00               54.15  1.10  13.. 

France   11.30               53.  4.20  32.50 

Italy 13.30               66.  2.60  15. 

Belgium 4.30               12.60  1.92  6.55 

Germany 1.45               50.  0.40  21. 

Austria 11.20               73.  4.20  26. 

Note:    In  the  past  three  years,  conditions  in  all  these  nations  have  grown 
worse,  with  the  exception  of  Great  Britain. 


Belgium  has  not  suffered  severely  compared  with  the  other 
Allies.  Her  recent  debt  per  capita,  of  $250  is  practically  the 
same  as  the  per  capita  of  the  United  States  it  will  be  noticed. 
Of  course,  the  cost  of  carrying  her  debt  is  heavier  than  that  of 
the  United  States,  which  is  shown  by  comparing  "Debt  charges 
per  capita,"  but  this  figure  is  still  very  favorable. 

When  we  come  to  national  wealth  and  national  income, 
Belgium  suffers,  failing  to  have  as  many  natural  resources  as 
other  nations.  The  result  is  that  the  per  cent  of  debt  charges 
to  the  national  income  of  the  country  rises  above  6|%  as  com- 
pared with  2|%  for  the  United  States,  but  Belgium's  necessity 
for  using  6.55  cents  out  of  every  dollar  to  pay  the  interest  on 
her  debt  is  still  low  as  compared  with  other  European  nations. 


70  I  nv  e  s  tni  6  71 1  S  ec  u  ri  tie  s 

Methods  of  Obtaining  Income 

Having  established  the  position  of  the  different  countries  in 
1919,  as  regards  percentage  of  debt  charges  to  national  income, 
it  seems  to  us  that  the  next  interesting  consideration  should  be 
their  relative  financial  sagacity.  We  know  of  no  better  way  to 
judge  this  question  than  by  the  methods  used  by  the  different 
nations  in  meeting  their  war  expenditures.  Increasing  taxation 
is  not  easy  for  any  nation,  and  a  lazy  financial  method  would 
have  been  to  raise  as  large  a  portion  of  the  money  needed  as 
possible  by  patriotic  loans.  The  table  below  will  show  what 
the  various  nations  accomplished  during  the  war  period. 

PERCENTAGE   OF  TOTAL  WAR   EXPENDITURES   OBTAINED   BY 

TAXATION 

United  States    26% 

Great  Britain    25 

France   153^ 

Italy    15 

Germany 11 

(Figures  for  Belgium  are  not  available.) 

Germany  was  notorious  for  her  extreme  dependence  upon 
loans  for  war  expenditures,  which  was  based  on  the  expectation 
of  an  early  victory.  It  proved  to  be  a  course  which,  entered 
upon,  could  not  be  discarded. 

The  failure  of  France  and  Italy  on  the  other  hand,  to  do 
better,  can  be  considered  in  some  degree  an  indictment  of  both 
nations.  If  it  was  felt  by  the  Ministers  of  Finance  that  the 
people  could  not  or  would  not  stand  any  heavier  taxes,  that  of 
itself  is  not  a  bull  argument  on  the  securities  of  the  nation.  At 
any  rate,  the  failure  of  the  Ministers  to  do  better  is  one  of  the 
reasons  why  France  and  Italy  are  in  the  weakest  position  of  all 
the  Allies. 

Expansion  of  Note  Issues 

In  all  nations,  the  outstanding  currency  has  been  increased 
tremendously  as  a  result  of  war  conditions.      Among  European 


Government    Bo  71  ds  71 

nations,  this  inflation  in  many  quarters  has  reached  alarming 
proportions.  The  position  of  various  countries  late  in  1919  as 
compared  with  pre-war  conditions  is  given  in  the  table  below. 
The  figures  show  the  note  circulation  per  capita  just  prior  to 
the  war  and  late  in  1919,  also  the  ratio  of  reserves  to  liabilities 
in  the  various  central  banking  systems. 


Pre-war  note          1919  note  Pre-war  Recent 

circulation           circulation  ratio  of  ratio  of 

per  capita            per  capita  reserves  reserves. 

United  States  $6.70                $32                      98.5%  45% 

Great  Britain 4.84                   51                      40  20 

France   32.49                 172.40                 60  15 

Italy 14.11                   74                      62  9 

Belgium 24.29  115.17 

Germany 7.93                 150                      60  2.50 

Austria  Hungary 6.25                 165                      72  0.50 

Note:    In  every  one  of  these  nations,  except  Great  Britain,  note  circula- 
tion has  continued  to  grow.- — ^January,  1923. 


Here  again,  we  are  forced  to  call  attention  to  the  position  of 
both  Italy  and  France.  The  expansion  in  the  note  circulation 
of  Italy  has  been  rapid,  but  the  note  circulation  per  capita  of 
France  at  the  present  time  is  tremendous. 

In  depreciated  currency,  the  Central  Empires  are  practically 
hopeless.  When  we  consider  that  the  ratio  of  reserves  in  the 
central  banking  institutions  of  Germany  have  declined  from 
60%  to  a  little  over  2%,  and  in  Austria  Hungary  from  72%  to- 
about  one-half  of  one  per  cent,  the  situation  is  plain.  This 
table  readily  makes  clear  the  reason  for  the  German  mark 
selling  where  it  does  and  for  the  Austrian  krone  being  prac- 
tically worthless.  We  see  little  hope  for  improvement  and 
nothing  in  the  situation  on  which  to  base  bullish  speculation. 
Irrespective  of  business  conditions,  the  constant  outpouring  of 
new  notes  in  these  countries  prevents  any  monetary  improve- 
ment. 

Here  again  the  position  of  Belgium  and  Great  Britain  standi 
out  as  much  more  favorable. 


72  Investment  Securities 

Domestic  Securities  Preferable 

In  addition  to  the  high  rates  paid  by  the  foreign  govern- 
ments for  money,  American  investors  are  often  approached 
with  the  argument  that,  owing  to  the  great  depreciation  in 
foreign  exchanges,  considerable  profit  as  well  as  a  high  return 
will  accrue  when  the  exchange  returns  to  normal.  The  figures 
given  above  as  regards  note  circulation  in  France  and  Italy  as 
well  as  in  the  Central  Powers  show  that  the  return  of  the  cur- 
rency of  those  countries  to  normal  will  be  very  difficult  to  bring 
about.  It  will  be  years  before  it  eventuates  and  in  some  cases 
such  a  development  at  all  is  extremely  questionable. 

On  the  other  hand,  American  long-term  bonds  are  now  selling 
nearly  as  low  as  at  any  time  in  fifty  years.  A  purchase  of 
them  will  not  only  give  a  sustained  return  over  a  long  period, 
but  also  considerable  appreciation  in  price.  For  this  reason,  we 
feel  that,  outside  of  the  high-grade  English,  Neutral  European 
nation's,  and  Canadian  bonds,  investors  should  confine  purchases 
to  United  States  issues. 


CHAPTER  IX 
MISCELLANEOUS   ISSUES 

Municipal  Bonds 

The  term  "Municipal"  is  used  to  apply  to  bond  issues  put 
by  a  city,  state,  county  or  township.  Such  bonds  are  obliga- 
tions of  definite  municipalities  and  the  principal  and  interest  is 
payable  from  taxes.  The  purpose  of  their  issue  is  to  finance 
improvements  which  are  to  be  of  general  public  benefit.  In 
view  of  this,  the  position  of  municipal  bonds  is  a  strong  one.  The 
benefits  derived  from  their  sale  is  usually  plainly  visible  and 
each  improvement  makes  the  general  community  more  pro- 
gressive and  of  greater  value.  They  are  dependent  for  payment, 
not  upon  any  individual  conditions  or  industry,  but  upon  a 
community  that  has  benefited  from  their  issuance.  In  other 
words,  while  in  the  last  analysis,  like  government  issues,  they 
are  dependent  upon  the  good-will  and  integrity  of  the  people, 
they,  of  themselves,  further  such  good-will  and  contentment. 

Methods  of  Payment 

We  have  said  that  municipal  bonds  depend  upon  taxing 
power,  or  ultimately,  the  good-will  of  the  people,  for  their  pay- 
ment. There  are,  however,  certain  distinctions  in  municipal 
bonds,  which  should  be  pointed  out.  The  majority  are  payable 
by  the  collection  of  taxes  placed  against  all  the  assessed  property 
of  a  community.  Some  are  made  payable  from  special  taxes  or 
from  revenue  derived  from  the  improvement  itself.  In  such  a 
case,  however,  the  municipality  as  a  whole  stands  behind  the 
issue  and  payment  is  thus  assured  even  if  the  special  work 
proves  disappointing.  Bonds  of  this  type  are  those  issued  by 
municipalities  for  waterworks,  or  perhaps  playground  or  agri- 
cultural works.     Another  type  are  payable  from  taxes  simply 


74  InvestmentSeciirities 

levied  against  the  property  benefited,  in  direct  proportion  to 
the  benefits  received.  They  are  called  Special  Assessment 
Bonds.  School,  sidewalk  or  even  road  improvement  bonds  are 
often  issued  in  this  form.  These  bonds  require  a  more  thorough 
knowledge  of  local  conditions,  when  considering  purchase,  than 
•do  the  direct  municipal  issues. 

Tax  Position 

Municipal  bonds  are  exempt  from  the  Federal  income  taxes. 
In  addition  they  are  exempt  from  State  taxation  in  the  state  in 
which  they  are  issued.  For  example  a  Massachusetts  investor  can 
hold  Massachusetts  municipals  exempt  from  both  Federal  and 
State  taxation.  Recently,  considerable  agitation  has  arisen  against 
this  tax  exemption.  In  view  of  the  fact  that  the  general  com- 
munity benefits  from  the  improvements  against  which  bonds 
are  issued,   it  is  probable  that  municipalities  will  continue  to 

Public  Indst.  Indst. 

Year  Municipals      Rails  Utilities         Bonds  Pfds. 

1920  5.07%  6.88%  7.51%  7.56%  7.82% 

1919  4.62  5.96  6.30  6.57  7.25 

1918  4.54  5.79  5.66  6.46  7.19 

1917  4.22  5.10  4.91  5.97  6.98 

1916  3.97  4.75  4.46  5.26  4.48 

1915  4.35  4.89  4.81  5.57  6.83 

1914  4.28  4.92  5.01  5.96  6.88 

1913  4.30  4.41  4.90  5.35  6.42 

1912  4.15  4.26  4.80  5.18  6.16 

1911  4.06  4.23  4.77  5.17  6.25 

1910  4.00  4.21  4.79  5.25  6.23 

1909  3.90  4.08  4.71  5.16  6.13 

1908  3.82  4.35  5.11  5.90  7.09 

1907  3.90  4.30  4.91     '  5.76  6.97 

1906  3.60  4.01  4.56  5.18  6.32 

1905  3.40  3.91  4.43  5.19  6.34 

1904  3.35  4.05  4.60  5.81  7.33 

1903  3.31  4.10  4.63  5.69  7.27 

The  increase  in  the  return  to  be  obtained  from  municipal  securities  in 
the  last  seventeen  years  has  been  1.76%,  or  an  increase  of  53.33%  over  the 
•return  then  available. 


Miscellaneous   Issues  75 

have  the  advantage  over  private  corporations  in  obtaining  funds. 
Moreover,  in  event  of  new  legislation  on  this  subject  the  issues 
now  outstanding  would  not  be  affected.  As  a  matter  of  fact, 
the  elimination  of  the  tax  free  feature,  would  make  the  old 
issues  more  valuable.  The  foregoing  short  table  gives  the  in- 
creasing returns  to  be  obtained  from  municipal  issues  over  a 
series  of  years  and  shows  how  attractive  they  have  recently  been 
to  wealthy  investors  desiring  non-taxable  investments. 

Real  Estate  Bonds 

"Real  Estate  Bonds"  as  they  are  known,  are  series  of  bonds 
issued  by  a  mortgage  company  formed  for  that  purpose.  They  are 
secured  by  mortgages  on  real  estate.  They  really  do  not  differ 
from  an  ordinary  mortgage  transaction.  There  are  a  large 
number  of  companies  engaged  in  this  business  in  this  country. 
The  strong  feature  of  bonds  of  this  type  is  the  stability  of  or 
constant  increase  in  the  values  behind  them.  Moreover  the 
value  of  real  estate  to  industry  of  all  kinds  assures  a  constant 
if  not  increasing  return  from  its  use. 

Elements  of  Risk 

It  must  not  be  be  presumed,  however,  that  on  account  of 
this  stability  of  value  and  income,  there  is  no  risk  attached  to 
this  type  of  investment.  The  risk  lies,  not  in  the  question  of 
real  estate  as  an  industry,  but  in  such  factors  as  the  following: 

Changes  in  certain  real  estate  values  Depreciation 

Rental  during  depression  periods  Judgment  in  values 

It  will  be  seen  immediately  that  the  questions  given  above 
apply  rather  to  residential  and  business  real  estate  than  to  farm 
land  or  buildings.  These  risks  can,  however,  be  carefully 
minimized.  This  is  done  by  our  strongest  bond  and  mortgage 
companies.  Changes  in  real  estate  values  do  not  occur  from  a 
nation-wide  standpoint,  except  a  change  toward  higher  values. 
Changes  in  local  conditions  can  be  minimized  by  scattering  the 
investment.     That  is,  in  a  series  of  bonds  secured  on  real  estate, 


76  I nv e Sim  en  t  S ecuriti e  s 

the  latter  should  be  chosen  from  differing  localities,  where 
possible.  If  not  possible,  the  bonds  should  be  secured  on  real 
estate  in  various  portions  of  the  same  city.  Depreciation  can 
be  carefully  allowed  for  and  that  this  is  done  should  be  noted. 
Diversification  will  offset  the  question  of  rentals  during  de- 
pression. This  means  diversification  of  industry  as  well  as 
locality.  Judgment  in  valuing  brings  in  the  human  equation. 
The  investor  can  see  that  precautions  have  been  taken  to  insure 
a  judicial  appraisal.  Such  care  is  scrupulously  exercised  by  our 
large  real  estate  bond  houses. 

Advantages  and  Disadvantages 

Real  estate  bonds  assure  stability  of  price  as  well  as  income 
and  value,  if  well  chosen.  They  are  usually  issued  for  a  short 
term.  These  factors  make  them  a  much  sought  after  invest- 
ment by  discerning  investors  during  periods  of  advancing  com- 
modity prices.  The  recurring  maturities  give  the  investor  the 
opportunity  to  obtain  the  increasing  returns  that  are  bound  to 
follow  rising  prices.  On  the  other  hand,  an  investment  in  real 
estate  bonds  is  not  so  attractive  during  a  period  of  declining 
commodity  prices,  as  the  desire  of  every  investor  in  such  a 
period  should  be  to  get  into  sound  long  term  issues  that  give  a 
high  return.  If  this  is  done,  not  only  will  the  investor  receive 
a  high  return,  but  also  appreciation  in  price.  Unless  bonds  are 
of  long  maturity,  this  is  not  possible. 

Federal  Farm  Loan  Bonds 

These  bonds  are  real  estate  bonds  with  a  fairly  long  maturity. 
While  they  are  not  an  obligation  of  the  United  States  Govern- 
ment, they  have  its  backing.  These  bonds  can  only  be  first 
mortgages.  The  Federal  Farm  Loan  system  was  formed  in 
1917,  with  an  elaborate  organization,  to  loan  money  to  our 
farmers.  The  bonds,  which  have  been  offered  to  the  public, 
are  secured  by  loans  made  up  to  50%  of  the  appraised  value  of 
farm  land  and  up  to  20%  of  the  permanent  improvements.  The 
uses  to  be  made  of  these  loans  must  be  stated  clearlv  and  ex- 


Miscellaneous    Issues  77 

treme  care  is  used  in  making  the  appraisals.  The  bonds  run 
for  twenty  years  and  are  issued  in  denominations  of  $25.  $50, 
$100,  $500,  and  $1,000. 

Repayment  of  Loans 

The  holders  of  these  bonds  are  further  protected  by  very 
stringent  restrictions  in  regard  to  the  repayment  of  the  loans. 
Every  mortgage  contains  an  agreement  that  the  borrower  will 
repay  on  an  amortization  plan.  He  must  pay  an  amount  at 
least  annually  sufficient  to  cover  interest  charges  and  all  expenses; 
also  an  amount  sufficient  to  retire  the  total  debt  within  an 
agreed  period.  This  period  cannot  be  less  than  five  years  nor 
more  than  forty. 

General  Liability 

Another  condition  that  is  of  great  value  to  the  prospective 
purchaser  of  these  bonds  is  that  not  only  is  the  Federal  bank  is- 
suing certain  bonds  liable  for  the  payment  of  the  interest  and 
principal  on  those  bonds  but  it  is  also  liable  for  the  bonds  put 
out  by  other  banks  in  the  system.  In  other  words,  a  joint 
liability  exists.  This  security  is  in  addition  to  the  security  of 
the  mortgage  itself. 

Tax  Exemption 

Federal  Farm  Loan  bonds  are  exempt  from  all  Federal  and 
state  taxes,  including  income  taxes.  As  in  the  case  of  municipal 
issues,  although  perhaps  more  pronounced,  there  has  been  con- 
siderable agitation  recently  against  this  tax  exemption.  It  has 
been  argued  that  the  entire  idea  of  the  Federal  Farm  Loan 
System  is  wrong,  that  it  is  class  legislation.  The  best  legal 
opinion,  however,  has  upheld  the  steps  that  have  been  taken. 
Bondholders  have  nothing  to  fear  from  such  an  agitation, 
because,  as  in  the  case  of  municipals,  whatever  is  done  in  the 
future  in  regard  to  tax  exemption  can  hardly  affect  outstanding 
issues.  Federal  Farm  Loan  bonds  form  one  of  the  most  attractive 
non-taxable  investments  available. 


CHAPTER  X 
READING  AN   OFFERING    CIRCULAR 

Position  of  Prospective  Investor 

Buying  investments  that  are  listed  on  our  large  stock  ex- 
changes, which  have  a  fairly  broad  market,  calls  for  analysis 
along  the  lines  indicated  in  the  foregoing  chapters.  Buying 
new  offerings  which  are  necessarily  unseasoned  and  for  informa- 
tion on  which  the  investor  must  rely  to  a  considerable  extent  on 
the  offering  circular,  calls  not  only  for  analysis  of  that  type,  but 
a  somewhat  more  detailed  inquiry. 

It  seems  to  us  that  in  scrutinizing  a  new  issue,  investors 
should  endeavor  above  all  else  to  keep  their  viewpoint  broad 
and  not  narrow  it  down  simply  to  the  statements  or  figures  given 
in  the  offering  circular.  Moreover,  analyzing  an  offering  cir- 
cular is  a  procedure  that  really  calls  more  for  a  strict  common 
sense  interpretation  than  for  anything  else.  It  must  be  re- 
membered, for  example,  that  the  issuing  corporation  stands  in 
the  position  of  submitting  all  possible  arguments  to  influence 
the  investor  to  loan  his  money,  or  become  a  limited  partner  in 
the  enterprise,  if  it  is  a  preferred  stock,  under  the  conditions 
stipulated  in  the  circular. 

The  mutual  interest  demands  a  high  degree  of  security.  It  is, 
however,  the  natural  desire  of  the  corporation  to  obtain  the 
money  on  as  favorable  terms  as  possible.  The  interest  of  the 
investor  is  to  get  as  high  a  return  as  possible,  at  the  same  time 
obtaining  a  high  degree  of  safety.  To  repeat  a  little,  we  will 
say,  in  illustration,  tliat  this  is  the  reason  why  most  bond  offer- 
ings at  the  present  time  are  of  short  term  nature.  Corporations 
do  not  wish  to  pay  high  rates  for  any  longer  time  than  is  neces- 
sary. Under  such  conditions,  investors  often  find  old  established 
seasoned  issues  that  are  far  superior  to  any  of  the  new  offerings. 


Reading   an   Offering   Circular  79 

Nature  of  the  Business 

In  taking  up  an  offering  circular,  it  seems  to  us  that  the  factor 
of  immediate  interest  is  the  nature  of  the  business  transacted 
by  the  company  offering  its  securities.  The  experiences  of  the 
past  five  years  have  shown  that  the  investor,  with  a  knowledge 
of  the  fundamentals,  will  gain  by  keeping  the  probable  trend  of 
interest  rates  and  commodity  prices  fixed  in  his  mind.  Under 
changing  conditions  he  makes  a  distinction  between  investments 
in  railroads,  public  utilities  and  industrials.  The  investor  im- 
mediately realizes  that,  under  advancing  commodity  prices,  for 
example,  the  public  utility  is  bound  to  operate  at  a  disadvantage 
compared  with  the  industrial,  so  under  such  conditions  he  favors 
industrial  investments,  under  declining  prices  —  vice  versa. 

The  next  consideration  should  be  in  regard  to  the  essential 
or  non-essential  character  of  the  business.  Under  this  considera- 
tion would  come  a  decision  as  regards  the  probable  future.  The 
difference  betw^een  the  outlook  of  electric  lighting,  gas,  electric 
power  or  street  railway  companies  as  a  class,  for  example.  If 
the  offering  was  an  industrial,  the  question  would  be  one  of 
luxury  or  staple  industry.  A  still  further  consideration,  under 
this  heading,  is  that  of  the  probable  expansion  of  the  business. 
Has  it  reached,  is  it  approaching  its  saturation  point,  or  does 
the  prospective  investor  feel  that  the  limits  of  expansion  are  far 
in  the  future? 

Location  of  the  Enterprise 

Here  again  the  factors  to  be  considered  differ  among  various 
types  of  enterprise.  In  a  public  utility,  for  example,  the  loca- 
tion of  the  enterprise  as  regards  the  cities  served  and  the  proba- 
bility of  their  future  growth  would  be  a  factor  of  great  impor- 
tance. Other  factors  would  be  the  transportation  facilities. 
If  a  steam  power  company,  the  proximity  of  hydro-electrics 
and  other  local  conditions  bearing  on  the  costs  of  opera- 
tion. In  an  industrial  the  question  of  locality  is  more  bound 
up  with  the  question  of  the  labor  supply  and  the  nearness  of  the 
market  for  the  product. 


'80  Investment  Securities 

Our  country  is  now  sufficiently  de\'eloped  so  that  with  the 
exception  of  a  few  short  line  properties,  the  location  of  our 
railroads  needs  little  study.  There  is  one  question  in  this 
field,  however,  that  is  coming  to  the  front.  That  is  the  location 
of  the  property  as  regards  growing  motor  truck  competition. 
In  considering  new  securities  from  the  standpoint  of  location  of 
the  property,  clients  can  profitably  re-read  Chapter  Five  in  the 
text,  "Launching  a  New  Enterprise,"  which  covers  this  factor 
from  the  standpoint  of  the  issuing  corporation. 

Capitalization 

This  question  is  of  more  common  nature  in  all  classes  of 
enterprise.  In  considering  it,  the  first  point  is  its  nature  or 
character.  What  proportion  of  the  company's  capitalization 
consists  of  stock?  What  of  bonds?  Here  again  we  can  refer 
clients  to  the  text:  "Launching  a  New  Enterprise,"  Page  32, 
under  the  caption:  "Determining  the  Corporation's  Financial 
Structure."  This  shows  particularly  the  relations  that  should 
be  established  between  the  bonds  and  preferred  stocks  of  an 
issuing  corporation  and  its  total  asset  values,  in  order  to  keep 
them  within  conservative  limits. 

Under  a  consideration  of  capitalization  should  come,  we 
believe,  the  question  of  equity  behind  the  present  offering. 
It  can  be  readily  appreciated  that,  if  the  offering  is  a  junior 
bond  or  preferred  stock  followed  by  a  relatively  small  amount 
of  common  stock,  such  equity  is  not  large.  If,  however,  the 
offering  is  a  first  mortgage  bond,  followed  by  an  equal  or  greater 
amount  of  j)referred  and  common  stocks  paying  a  good  dividend, 
the  stockholders  equity  in  the  property  is  valuable  and  is  in 
turn  an  added  security  behind  the  bond. 

Purposes  of  tlie  New  Issue 

The  next  factor  that  should  be  scanned  is  the  purpose  for 
which  the  new  bond  or  ])rcferred  stock  is  put  out.  If  it  is  for 
purposes  of  expansion,  is  it  the  opinion  of  the  investor  that  ap- 
proaching conditions,  as  he  views  them,  warrant  expansion  in 


Reading   an   Off  er  in  g   Circular  81 

that  particular  type  of  industry?  For  example,  at  the  present 
time,  in  view  of  the  developments  of  the  past  ten  years,  no  one 
would  question  the  wisdom  of  expansion  in  our  railroad  facilities. 
On  the  other  hand,  if  a  luxury  making  industrial  is  offering  a 
security  for  the  purpose  of  obtaining  funds  to  build  additional 
plants,  the  wisdom  of  such  a  course  after  four  or  five  years  of 
extraordinary  prosperity,  is  at  least  questionable. 

If  the  purpose  of  the  issue  is  to  replenish  working  capital, 
the  degree  of  accomplishment  should  be  studied  with  interest. 
That  is,  the  investor  should  figure,  from  the  balance  sheet  given, 
what  the  working  capital  position  of  the  company  was  prior  to 
receiving  the  money  from  the  new  issue.  If  its  position  was 
weak,  it  should  be  determined,  if  possible,  why  it  was  weakened, 
and  whether  the  turning  of  liquid  into  fixed  capital  will  be  justi- 
fied by  probable  future  developments.  The  investor  should 
make  up  his  mind,  to  his  own  satisfaction,  that  the  renewed 
working  capital  would  be  sufficient  to  carry  the  company,  as 
far  as  may  be  determined,  without  further  issues  of  notes  or  pre- 
ferred stock  in  the  immediate  future. 

Amount  of  the  New  Issue 

The  amount  of  the  new  issue  to  be  sold  should  be  studied 
in  relation  to  the  outstanding  obligations.  If  a  property  is 
issuing  bonds  or  preferred  stock  equivalent  to  its  outstanding 
bonds  or  preferred  stock,  or  if  a  company  is  placing  an  initial 
fixed  charge  against  the  property,  the  factors  behind  the  new 
issue  must  be  studied  much  more  carefully  than  in  the  case  of  a 
company  which  is  putting  out  bonds,  we  will  say,  equal  to  only 
about  25%  of  its  present  outstanding  indebtedness. 

Whether  the  mortgage  is  open  or  closed  should  be  considered. 
An  open  mortgage  will  doubtless  mean  further  issues  of  the  same 
type,  which  will,  of  course,  tend  to  depress  or  at  least  restrain 
the  price  of  the  present  issue  until  all  the  offerings  become  ab- 
sorbed and  seasoned. 

Retirement  features  are  another  point  of  interest.  If  the 
retirement  of  the  bonds  is  accomplished  through  a  sinking  fund 


82  Investment  Securities 

the  investor  can  rest  assured  that  his  position  will  improve  con- 
stantly as  the  sinking  fund  gradually  retires  the  issue.  If, 
however,  the  retirement  is  by  calling  as  a  whole  which  would 
take  in  all  the  issue  at  a  slight  premium  above  par,  its  value 
to  the  investor  is  more  questionable.  It  is  natural  to  suppose 
that  the  bonds  or  preferred  stock  will  not  be  taken  in  at  a  pre- 
mium unless  it  is  to  the  advantage  of  the  company  to  do  so. 
It  will  not  be  done  unless  the  company  is  in  a  strong  position. 
Under  these  conditions,  investors,  it  can  be  conceived,  might 
much  prefer  to  continue  the  investment  rather  than  lose  it. 

Here  again,  the  question  of  long  term  and  short  term  se- 
curities comes  up.  In  periods  which  forecast  declining  commod- 
ity prices  offerings  with  a  long  time  to  run,  without  retirable 
features,  are  to  be  desired,  given  a  high  degree  of  security. 
Short  term  notes  are  to  be  desired  under  opposite  conditions. 

Security 

In  considering  security,  the  mortgage  or  lien,  if  the  offering 
is  bonds,  should  be  taken  up  first.  Naturally  the  issue  most 
desired  is  a  straight  first  mortgage.  For  reasons  which  we 
have  discussed,  howe\xr,  such  issues  are  not  obtainable  in 
large  quantities,  particularly  among  our  stronger  corporations. 
In  considering  prior  liens  on  a  part  or  all  of  the  property,  they 
should  be  considered  from  the  standpoint  again  of  whether  they 
are  open  or  closed  mortgages  and  what  retirable  sinking  fund 
features  they  carry.  It  is,  of  course,  clearly  to  the  interests  of 
the  purchaser  of  a  general  or  second  mortgage  bond  to  have  the 
first  mortgage  issue  carry  either  a  sinking  fund  or  the  possibility 
of  redemption.  In  the  case  of  a  preferred  stock,  a  study  of 
the  security  should  consist  to  some  degree,  of  a  consideration 
of  the  value  of  the  restrictions  placed  around  it.  In  the  last 
analysis,  however,  the  preferred  stockholder,  being  a  partner  in 
the  enterprise,  depends  on  the  earnings  for  his  security. 

Earnings 

In  taking  up  the  question  of  earnings,  let  us  say  that  too 
many  offering  circulars  simply  give  the  latest  earnings.     This 


Reading    an    Offering    Circular  83 

is  a  mistake,  as  it  is  impossible  to  get  a  line  on  any  corporation 
from  a  study  of  a  single  yearly  period.  For  example,  the 
earnings  of  even  the  past  two  or  three  years  of  many  of  our 
industrial  properties  would  give  little  indication  of  what  they 
might  be  able  to  do  under  that  much  abused  term  —  normal 
conditions.  If  the  offering  circular  does  not  go  into  detail,  we 
feel  that  investors,  wherever  possible,  should,  of  their  own 
accord,  look  back  over  a  sufficient  period  to  take  in  both  de- 
pression and  prosperity  and  thus  get  a\'erage  conditions. 

It  must  be  remembered,  of  course,  that  surplus  earnings, 
plowed  back  into  a  property,  will  certainly  tend  to  develop  an 
increasing  ratio  of  net  earnings  to  fixed  charges,  irrespective  of 
depression  or  prosperit3^  With  this  qualification,  however,  a 
study  of  earnings  over  a  series  of  years  should  certainly  be  made. 
Not  only  the  margin  over  fixed  charges  should  be  considered,  but 
also  the  actual  costs  of  conducting  the  enterprise. 

The  statement  of  earnings  given  in  the  circular  should  be 
looked  at  carefully  to  determine  whether  the  fixed  charges  on 
the  new  securities  offered  are  included  in  the  total  charges 
given.  If  they  are,  and  the  earnings  as  given  do  not  include 
an  estimated  increase  from  the  improvements  to  be  made, 
such  a  statement  can  be  considered  as  thoroughly  conservative. 

Balance  Sheet 

The  most  important  item  to  a  prospective  investor  in  the 
balance  sheet  that  should  be  given  with  every  new  offering  is 
the  working  capital  position  of  the  company;  that  is,  the  ratio 
of  current  assets  to  current  liabilities.  The  text:  "Internal 
Financial  Management"  on  Page  27  discusses  this  factor  from 
the  standpoint  of  industrial  enterprises.  It  shows  that  on  the 
average,  the  working  capital  of  an  industrial  should  be  between 
45  and  50%  of  its  permanent  invested  capital. 

Public  utilities  and  railroads,  by  the  nature  of  their  business, 
do  not  require  anywhere  near  as  much  working  capital.  Their 
fixed  investment  is  very  large,  and  their  borrowing  ability  at 
the  banks  not  subject  to  the  same  fluctuation  as  an  industrial. 


84  1 71  vest  me?it  Securities 

In  considering  working  capital  position,  it  should  be  carefully- 
noted  whether  the  money  to  be  obtained  from  the  present  issue 
has  been  included  among  the  current  assets  or  not.  This  has 
been  discussed  under  the  caption  "Purposes  of  Issue."  If  it  has, 
it  will  of  course,  make  the  working  capital  look  large,  and  the 
position  of  the  company  before  the  new  financing  should  be 
noted. 

Summary 

It  is  impossible,  in  a  limited  discussion,  to  go  into  detail  in 
regard  to  these  various  points.  We  do  feel,  however,  that  after 
a  client  has  become  convinced  that  the  return  on  the  invest- 
ment offered  appeals  to  him  he  should,  speaking  broadly,  follow 
the  various  steps  outlined  here.  If  he  can  satisfy  himself, 
through  his  knowledge  of  fundamental  conditions,  taking  into 
consideration  probable  developments  over  the  next  few  years, 
that  the  factors  above  enumerated  are  favorable  he  may  be 
quite  sure  that  the  investment  is  warranted.  Even  under  such 
conditions,  however,  we  would  warn  against  believing  that  any 
investment  may  be  laid  away  and  forgotten.  The  experience 
of  the  past  ten  years  is  all  that  is  needed  to  show  investors 
the  necessity  of  regularly  following  the  development  of  the 
country,  the  trend  of  commodity  levels,  interest  rates,  and  the 
developm.ent  of  social  conditions  in  order  to  watch  their  invest- 
ments, and  keep  security  and  return  at  favorable  levels. 


TEST   QUESTIONS 

"INVESTMENT  SECURITIES" 

The  test  questions  outlined  below  refer  directly  to  the  text 
discussion.  You  will  find  them  helpful  in  bringing  out  the 
vital  points  in  the  individual  discussions.  They  may  also  be 
used  for  review. 

1.  Define  yield  and  annual  return. 

2.  Discuss  the  differing  t^^pes  of  corporation  bonds. 

3.  What  are  the  permanent  factors  affecting  bond  prices? 

4.  Describe  the  last  complete  cycle  of  bond  prices. 

5.  Describe  the  temporary  trend  of  bond  prices  and  what 

causes  it. 

6.  Do  you  consider  railroad  bonds  good  purchases?     Why? 

7.  What  are  the  strong  features  behind  public  utility  bonds? 

8.  What  is  the  reason  for  their  present  low  prices? 

9.  If  you  were  buying  an  industrial  preferred  stock,  what 

type  would  you  buy  and  why? 

10.  What  do  you  think  of  French  and  Italian  bonds? 

11.  How  would  you  study  a  real  estate  bond? 

12.  What  are  the  different  types  of  municipal  issues? 


ANALYSIS   OUTLINE   FOR   UTILITY   COMPANIES 

Utility  companies,  handicapped  by  the  war,  are  now  return- 
ing to  the  strong  position  they  previously  held.  In  analyzing 
public  utility  securities,  all  the  points  outlined  below  should  be 
kept  strongly  before  the  prospective  investor. 

1.  Franchises 

(a)  Type? 

(b)  Do  they  run  beyond  maturity  of  bonds? 

2.  Rates 

(a)  On  what  based? 
(&)   Cost  of  service? 

(c)  What  the  community  will  stand? 

3.  Value  of  Plant 

(a)  Per  cent  in  excess  of  bonds  outstanding? 

(b)  Asset  value  of  common  stock? 

4.  Capitalization 

(a)  Per  cent  bonds,  per  cent  stock? 

(b)  Securities  issued  under  approval  of  commission? 

5.  Earnings 

(a)  Number  of  times  bond  interest  earned? 

(b)  Operating  ratio  favorable? 

(c)  Fluctuations  over  series  of  years? 

(d)  Per  cent  of  growth? 

(e)  Per  cent  decline  in  previous  depressions? 

6.  Bonds 

(a)  Value  of  plant  over  bonds  outstanding? 

(b)  Junior  or  senior  mortgage? 

(c)  Mortgage  closed? 

(d)  Callable?     At  what  price? 

7.  Business  Field 

(a)  Present  size? 
(&)  Recent  growth? 

(c)  Transportation  facilities? 

(d)  Industries  diversified? 

8.  Management 

(a)  Conservative  or  risky? 

(b)  Maintenance  charges  liberal? 

(c)  Per  cent  of  earnings  paid  in  dividends? 
((f)  Has  it  strong  financial  backing? 


Garden  City  Press,  Inc. 
Newton,  Mass. 


UNIVERSITY  OF  CALIFORNIA,  LOS  ANGELES 

THE  UNIVERSITY  L^^^  -^"Y 

This  book  is  DUE  on  the  I"*    cil^lHh^    ^elow 


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